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Conditions for Capital Market Development


R t

AR t

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E ( R t | X t )

(1.4)

Conditions for Capital Market Development


Where, AR it , R it , and E(R it |X t ) are the abnormal return, actual return, and expected return of stock i on day t , respectively . X t is the event information related to the price of the stock under study.

The expected return of stock i on day t is determined by the following market model



R it

ii R mt

E ( it



it

0) var(


it )

(1.5)


2

i

Where R it and R mt are the returns of stock i and of the market index in

i , i ,

2

i

day t . are parameters of the market model.


The time sequence used in this method is shown in Figure 1.3:




In which the period from (T 0 :T 1 ) is called the estimation window, which is the period of time with data used to estimate the parameters of the market model in formula (1.5). The length of this estimation window for studies using daily stock price data is usually 120 to 200 days. The period from (T 1 :T 2 ) is called the event window, in which time 0 is the time when the event occurs. The length of this window ranges from 1 to 5 days, a shorter time is considered to determine more accurately the impact of the event on the stock price. The stock price in this event window is used to determine the abnormal return in the event window in formula (1.5).

With the data in the estimation window, we can determine the parameters in formula (1.5), the abnormal return of stock i on day t of the event window is



AR it


R it


^ ^

ii R mt


(1.6)


The abnormal return is the residual of the market model calculated outside the estimation window. This abnormal return is normally distributed and when the length of the estimation window is large enough, the variance of the abnormal return will approximate the variance of the residual in the market model in formula (1.5).

For each individual security, the abnormal returns obtained from formula (1.4) can be summed and averaged for each day in the event window. For a given N events, the average abnormal return on day t in the event window is


AR t

1 N

N i 1

AR it


(1.7)


And with a sufficiently large number of days in the estimation window, the variance of the average abnormal return on day t in the event window is



1

N 2

N

2

i

var( AR t )

(1.8)


2

i

Since the total sample variance is unknown, we will use the standard deviation


Adjust the estimate obtained from the market model to the corresponding abnormal return.

^ 2


i

to calculate the variance of the

This average abnormal return can be summed over the event window to calculate the cumulative abnormal return for security i.


CAR ( t 1 , t 2 )

t 2

AR t

tt 1


(1.9)


var( CAR ( t 1 , t 2 ))

t 2

var( AR t )

tt 1


(1.10)


Similarly, for M different securities, the cumulative abnormal return can be averaged over the M securities and the corresponding variance is calculated as follows



CAR ( t , t )

( t , t )

(1.11)

1

M

M

CAR

i 1

i

1 2 1 2


var( CAR ( t , t )) 1 M var ( CAR )


(1.12)

M

1 2 2 it

i 1


Conclusions about the average cumulative abnormal return can be derived using the probability distribution


CAR ( t 1 , t 2 ) ~ N [0, var( CAR ( t 1 , t 2 ))]

(1.13)


With the hypothesis H 0 that the average cumulative abnormal return over the event window is zero. The test statistic in this case is



CAR ( t 1 , t 2 )

t

var( CAR ( t , t )) 1 / 2

~ N [0,1]

(1.14)

1 2


If there is evidence to reject the null hypothesis H 0 , we can conclude that stock prices have changed to reflect new information released to the market and that the market is averagely efficient [90].

For strong market efficiency, the tests involve examining whether trades by insiders or a group of fund managers who are better informed than ordinary investors can achieve results that are higher than the average market return.

Empirical studies in the field of finance have provided evidence in support of the efficient market theory (in the US). These results can be summarized as follows:


(1) The performance of professional investors and investment fund management companies is not better than the average performance of the market. This proves that the stock price has been determined efficiently by the market and there is no opportunity to seek profit from price differences;

(2) The stock price already includes information about expected profits, or information about expected stock splits, only information different from the expected will change the stock price on the market;

(3) Stock prices fluctuate in an unpredictable random sequence;


(4) and technical analysis does not yield results higher than the average market return.

However, there are also some phenomena that have been documented that show that the capital market (in the US) is inefficient. These phenomena include: small firms tend to have higher than average long-term earnings (small firms effect); stock prices tend to increase above average from December to January (January effect); stock prices in the market tend to overreact (market overreaction) and fluctuate greatly (excessive volatility) to new information in the market; and the mean reversion effect (mean reversion) [89].

The above evidence is collected based on stock data on stock markets in the United States. The empirical evidence of market efficiency is also extended to other commodity markets in many different countries.

1.2.3 Conditions for capital market development

From the perspective of capital market functioning, capital markets cannot develop without a solid foundation for their operation. These foundations and mechanisms are necessary to maintain public confidence and to encourage the efficient operation of capital markets.


1.2.3.1 Government administration:


Government regulation plays a key role in establishing the foundations for capital markets. These foundations include the enforcement of civil transaction commitments, a transparent operating environment, and the protection of property rights. Experience from developed countries shows that government regulation of financial markets should be based on the principle of supervision of decision-making and responsible entities, such as stock exchanges or brokerage firms. The autonomy of market entities is based on the capacity and decisions of individuals directly involved in market transactions, who have the most authentic knowledge of what is happening on a daily basis and thus are better than administrative regulation by government agencies.

1.2.3.2 Premises for capital market development:


The World Bank has laid out the foundations for the development of the financial system, in which issues directly related to the development of the capital market include:

(1) Company law: the operations of joint stock companies are related to the interests of shareholders, creditors, and other interested parties, including employees. In joint stock companies, there is a separation between owners and company managers, creating a control structure through representatives of owners (such as the board of directors or independent auditing companies). With hundreds or even millions of shareholders, individual shareholders have little influence on the company's business operations. Therefore, it is necessary to have regulations on the responsibilities and powers of parties related to the company's operations to resolve conflicts of interest that arise between related parties.

(2) Bankruptcy and reorganization law: when a company goes bankrupt, there must be clear regulations on the order and procedures for bankruptcy and on the rights of shareholders.


creditors. When a company is having difficulty paying its debts, restructuring the company may be more beneficial to creditors than closing down and selling the troubled company’s assets. Restructuring may involve adjusting the schedule of principal and interest payments, reducing the company’s debt obligations (by converting debt into equity), or reducing or canceling the company’s debt. Restructuring also creates conflicts of interest between creditors and current managers, as weak managers may lose their jobs if the company defaults and has to undergo a restructuring. Restructuring also becomes more difficult as the number of creditors increases. Therefore, regulations are needed to ensure that a small number of creditors cannot block a restructuring plan for the benefit of the majority of creditors. Bankruptcy and corporate restructuring laws are poorly developed and implemented in very few developing countries.

(3) Timely and accurate accounting: investors need to have accurate information about the financial situation of enterprises to make appropriate investment decisions. Accounting standards, “generally accepted accounting principles”, have been applied by many countries such as the US, Europe, and Japan to provide information to investors outside the company. “Accounting and auditing activities in developing countries are sometimes weak, financial reports are not prepared on time and accurately… Therefore, developing a team of accounting and auditing professionals is extremely important to establish effective financial markets” [36].

(4) Prudential regulations for financial markets: these regulations relate to the disclosure of information about companies; regulations on granting business registration to securities companies, the charter capital of securities companies; regulations to prevent insider trading. These regulations are necessary to further strengthen the confidence of investors.


(5) Prudential regulations for the operations of financial intermediaries, especially those governing the operations of commercial banks: regulations governing commercial banks include the following aspects: regulations on remote and on-site supervision; granting of business licenses; regulations on capital adequacy ratios, asset classification and provisioning, solvency, investment concentration; regulations on bank restructuring; auditing standards and financial information disclosure. These regulations are important because financial intermediaries play an important role in the capital market. Banking crises can cause serious declines in the capital market and are very costly to restore [36].

In addition to the foundations of the financial system, the World Bank also found that the causes of underdevelopment of capital markets in many developing countries are the absence of appropriate legal regulations, market governance and tax policies [36].

1.2.3.3 Regulations on investor protection


In addition to legal regulations in the securities sector, regulations protecting investors also play an important role in the development of capital markets. La Porta and the authors found evidence that legal regulations protecting investors are important factors determining the development of capital markets [97].

The rights of investors or owners in joint stock companies can be divided into the following 6 basic groups:

1. The right to vote for the board of directors as well as important corporate matters such as mergers or dissolutions. The right to vote is exercised at annual or extraordinary general meetings of shareholders. If investors are unable to attend the meeting, they can send their ballots in advance by mail or authorize one or more other people to vote who will attend the meeting. The voting mechanism can be implemented according to the election principle


majority or cumulative voting. The majority voting mechanism makes it impossible for small investors to elect managers according to their wishes because they account for less than 50% of the total votes. In the cumulative voting mechanism, small shareholders can elect the management position they want by accumulating votes from other positions.

2. Partial ownership of a company in proportion to the number of shares held. This right is linked to the distribution of remaining assets when the company goes bankrupt, liquidates or dissolves. In many cases, current shareholders also have priority in purchasing newly issued shares to ensure their respective ownership ratio in the issuing company.

3. Right to transfer shares held by investors. Except in cases of specific transfer restrictions, shareholders can freely transfer the shares they hold in the financial market.

4. Right to receive dividends. The dividend rate is decided by the board of directors, however, when the company pays dividends, all shareholders receive them.

5. The right to inspect the company's books and financial statements. In public companies, financial statements and annual reports are often required to be made publicly available to investors. This right is more important for non-public joint stock companies.

6. The right to sue managers for wrongdoing. Conflicts of interest between managers and shareholders can lead to wrongdoing by the board of directors. Shareholders of a company may have the right to sue the board of directors, as was recently the case in the fraud cases at WorldCom and Enron in the US in 2002.

Investor rights may vary by country or region. Although shareholders are the ultimate beneficiaries of a company when it goes bankrupt or is dissolved, owning a portion of the company still has good opportunities such as stock price appreciation. Investors who understand their rights can avoid risks, while the authorities always try to protect shareholder interests to a certain extent.

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