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Market Efficiency and Limits to Arbitrage in Advanced Emerging Market Efficiency and Limits to Arbitrage in Advanced Emerging Markets An independent thesis submitted in fulfilment of the requirements for the degree of Doctor of Philosophy in Accounting and Finance (University of Newcastle) Mostafa Seif BSc in Civil Engineering (University of Tehran) Master of Project Management (University of New South Wales) Master of Applied Finance (University of Newcastle) Newcastle Business School Faculty of Business and Law UNIVERSITY OF NEWCASTLE August 2016 I | Page Statement of Originality The thesis contains no material which has been accepted for the award of any other degree or diploma in any university or other tertiary institution and, to the best of my knowledge and belief, contains no material previously published or written by another person, except where due reference has been made in the text. I give consent to the final version of my thesis being made available worldwide when deposited in the University’s Digital Repository**, subject to the provisions of the Copyright Act 1968. **Unless an Embargo has been approved for a determined period. Mostafa Seif August 2016 II | Page Statement of Authorship I hereby certify that the work embodied in this thesis contains a published paper/s/scholarly work of which I am a joint author. I have included, as part of the thesis, a written statement endorsed by my supervisor attesting to my contribution to the joint publication/s/scholarly work. Signed: ……………………………… Date: ……………………………….. The following conference papers are the outcomes of the following thesis: • Seif, M., Docherty, P., Shamsuddin, A., (2016) “Seasonal anomalies in advanced emerging stock markets.” Conference on Applied Financial Modelling, 4 -5 February, Melbourne, Australia • Seif, M., Docherty, P., Shamsuddin, A., (2016) “Limits to arbitrage and the MAX effect in emerging markets.” Portsmouth – Fordham Conference on Banking & Finance, 24 – 25 September, Portsmouth, UK III | Page Acknowledgement First and foremost, I would like to express my deepest gratitude to my research supervisors, Professor Abul Shamsuddin and Dr. Paul Docherty for supporting me through all the ups and downs of my PhD candidacy. I thank my supervisors for all their help and support and their patience and guidance through all these years. Abul has always been a professional mentor. His work ethics and his kindness are among his various qualities that I look up to. He has greatly improved my dissertation with his insightful comments and his statistical expertise. Paul has been more than a supervisor to me and helped me as a friend even before I enrolled as a PhD candidate. I am extremely fortunate to be able to work with two supervisors who have endlessly supported both my career and personal development. Without them, I would never have been able to go this far. I would like to express my deepest appreciation to the love of my life, Maedeh, who spent sleepless nights with me and was always my support in the moments when there was no one to answer my queries. She literally put my career before hers and supported me through all these years. I thank her for supporting me spiritually throughout writing this thesis. Her understanding and love during the past few years was in the end what made this dissertation possible. Last but not least, I would like to thank my parents, Valiollah Seif and Shayesteh Moghaddam, whom I could not be where I am today without them. I thank them for all the moral support and the amazing chances they have given me over the years. They have been so supreme, nurtured my learning and supported my dreams. Writing this thesis was impossible without their encouragement. IV | Page Abstract This thesis has two key motivations. The first is to undertake a comprehensive examination of the market characteristics and institutional features across nine ‘advanced emerging’ stock markets: Brazil, Czech Republic, Hungary, Malaysia, Mexico, Poland, South Africa, Taiwan and Turkey. After identifying that these markets comprise characteristics that may restrict rational investors from arbitraging away identifiable mispricing, the second purpose of this thesis is to examine the level of market efficiency and the relation between mispricing and limits to arbitrage. Given limitations with the depth and quality of accounting information across emerging markets, the issue of market efficiency is examined by testing whether returns and volatility-based anomalies that have been identified in developed markets are also evidenced across this sample. More specifically, this thesis examines the prevalence of seasonality in both returns and volatility of returns with respect to five calendar anomalies that have been identified in the context of developed markets. In addition, this thesis examines whether there is evidence of a negative relationship between maximum one-day returns and subsequent monthly returns (referred to as the MAX effect) in advanced emerging markets. Despite an extensive number of studies documenting evidence of seasonal anomalies and the MAX effect in developed markets, which indicates that these markets are less than perfectly efficient, this thesis provides the first comprehensive examination of this issue across advanced emerging markets. This thesis also expands the existing literature by examining the potential sources of such anomalous returns and the existence of mispricing in these markets by V | Page testing whether the returns can be explained by risk-based pricing models or time series variation in limits to arbitrage. The results of this thesis provide evidence of the existence of strong anomalous returns, which indicates a high level of mispricing across advanced emerging stock markets. Specifically, this thesis finds that, on average, returns are higher during the month of December, the 44th week of the year, Fridays and pre- and post-holidays; and these anomalous returns are not explained by seasonal variation in volatility. Moreover, this thesis reports evidence of a strong MAX effect that is persistent after controlling for size, book to market ratio, market beta, momentum, short-term return reversals and liquidity. The magnitude of the mispricing associated with the MAX effect appears to be higher in advanced emerging markets compared with developed markets. The zero-investment returns generated by the MAX effect are shown to co-vary with time series variation in limits to arbitrage. Taken as a whole, these results suggest a lower level of efficiency across advanced emerging markets that can be explained by the market characteristics and institutional features that restrict the ability of rational investors to arbitrage away mispricing. The results reported in this thesis can therefore allow investors to better understand the characteristics of risk and returns in advanced emerging markets in order to develop improved asset pricing models in the context of these markets. In addition, the demonstrable link between asset pricing anomalies and limits to arbitrage may provide policy makers with a framework for improving the efficiency of their stock markets by mitigating market frictions through investor protection measures, and relaxation of capital controls and short-selling restrictions, among others. VI | Page Table of Contents Chapter 1 : Introduction .......................................................................................... 1 1.1. Thesis background .................................................................................... 2 1.2. Research questions ................................................................................... 7 1.2.1. Do advanced emerging markets exhibit seasonal patterns in stock returns? ........................................................................................................... 8 1.2.2. Do advanced emerging markets exhibit the MAX effect? .............. 19 1.3. Thesis outline ......................................................................................... 21 Chapter 2 : Overview of advanced emerging markets .......................................... 25 2.1. Introduction ............................................................................................ 26 2.2. Regulatory and institutional framework in emerging markets ............... 29 2.2.1. Equity market liberalization ............................................................ 29 2.2.2. Exchange rate regime ...................................................................... 40 2.2.3. Social institutions and culture ......................................................... 45 2.2.4. Corporate governance ..................................................................... 50 2.2.5. Fiscal year ....................................................................................... 60 2.3. Market characteristics ............................................................................. 61 2.4. Stock return and volatility patterns ........................................................ 67 2.5. Geographical location ............................................................................. 76 2.6. Conclusion .............................................................................................. 80 VII | Page Chapter 3 : Seasonal anomalies in advanced emerging stock markets ................. 84 3.1. Introduction ............................................................................................ 85 3.2. Literature review .................................................................................... 87 3.2.1.
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