An Empirical Examination Of The Stock Return Dynamics Of Developed, Emerging And Frontier Markets

Over the past five decades, there has been an increasing interest in investigating the theoretical and empirical basis for Efficient Market Hypothesis (EMH). Generally, the EMH is underpinned by the principle of rationality with an implication that the activities of competing market participants will cause a fully accurate and instantaneous incorporation of all available information into actual pricing of a financial asset (see Fama, 1965). By contrast, the behavioural finance theorists document the violations of market rationality on the basis of behavioural biases exhibited by economic agents in decision making under uncertainty (see Kahneman and Tversky, 1982 De Bondt and Thaler, 1985, Dissanaike, 1997 Barber and Odean, 2001). Some of the prevailing market imperfections attributed to behavioural biases in investment decisions include loss aversion, overconfidence, underreaction, overreaction, momentum effect, herding behaviour and sentiment.

In order to reconcile the efficient market with behavioural finance, Lo (2004) describes a new market framework from an evolutionary perspective, called the Adaptive Market Hypothesis (AMH). In rapidly changing economic conditions, the instantaneous adjustment of market prices may seem untenable as a result of market imperfections arising from information inefficiency. Therefore, the evolutionary nature of the market creates profit opportunities which may be exploited and eroded as financial market players learn to take advantage of them. An important implication of the AMH is that market efficiency varies continuously over time and across markets due to changing market conditions (see Lo, 2005 Kim et al., 2011 Urquhart and Hudson, 2013). Fundamentally, the evolutionary principles underpinning AMH can explain complex market dynamics, going through the cycles of bubbles and busts, expansions and contractions, which are common phenomena in natural market ecologies. The fact that the performance of investment strategies, including fundamental and technical analysis can perform well in certain market environments and poorly in others, suggests that investors may potentially arbitrage and exploit profit opportunities due to unstable risk-return relationship overtime.

However, there has been longstanding debate between professional investors belief in making considerable profits by predicting market returns and large swathes of academics position on the unpredictability of market returns. The reality is that the predictability of future returns based on historical information is fraught with dangers of huge investment losses particularly, if negative shocks hit the financial markets. As a result, professional traders would select the most profitable trading system that perform optimally in terms of eliminating the losses due to price shocks and perhaps make gains from their investment strategies. This is why comparing the performance of the trend-following systems capable of generating trading profit is crucial for investors and financial analysts. Despite financial markets being driven by economic fundamentals, most professional traders use both fundamental and technical analysis to determine the short-term direction of market prices.

It will be na ve for investors to think that a trading strategy that identifies a profit opportunity is risk-free. It is also inconceivable to conclude that return predictability can be economically exploited without taking into account transactions costs, taxes and other related costs. In any case, the use of technical analysis has a long history among practitioners particularly to speculate on profit opportunities in the markets. It is therefore critical for investors to evaluate profitability of technical trading strategies on a risk-adjusted basis in order to account for systematic and non-systematic risks. Primarily, investors can minimise non-systematic risk through diversification, while systematic risk can be mitigated through hedging or appropriate asset allocation strategies.

It is equally important to argue that the application of the AMH framework would have important implications on price discovery, market integration, financial contagion, asset allocation, portfolio diversification and risk management. Moreover, there is a plausible connection between the degree of market efficiency and market integration. We conjecture that markets with higher degree of efficiency are more likely to have stronger integration between them. The reason being that a risk-averse investor will potentially diversify more into markets with less market imperfections and frictions, hence increasing market integration.

The integration of financial markets has been broadly defined in the context of financial openness, unrestricted capital flows, integration of financial services and macroeconomic convergence. The openness of economies to trade and surge in international capital outflows have contributed to growing financial integration in the world, particularly among developed countries. Likewise, the process of globalisation is leading to the integration of economies, industries, markets and policy-making around the world. In fact, the level of interaction between macroeconomic fundamentals and financial stability is dynamically affecting policy-making and regulatory framework.

Since the Great Depression, unexpected events and shocks have introduced significant volatility and uncertainty into the financial markets. Particularly, asset price shocks are usually accompanied by high volatility. Hence, the growing financial integration is also evident by the level of transmission of shocks from one financial centre to the rest of the world with close immediate reactions. A recent example is the 2008 stock market crash triggered by the collapse of the fourth largest investment banks (Lehman Brothers Inc.) in US, led to economic crisis of her more influential trading partners in Europe, America and Asia. It is undoubtedly evident that the turbulence in the global economy is increasing volatility and uncertainty in an increasingly globalised financial markets. Therefore, the levels of shock and volatility transmissions from one country to another may contribute significantly to increasing financial market integration.

Overtime, recurrent economic changes have altered asset price relationships. For instance, countries have abolished capital and exchange controls for improved financial development floated their currencies, opened up their capital markets and promote financial liberalisation joined trade and monetary union to facilitate economic integration etc. For each of these events, there has been an alteration in price patterns, perhaps more or less volatile sometimes, and may also influenced the degree of financial integration between developed and developing markets.

Furthermore, the effects of price shocks either caused by a structural change (i.e. permanent price shift) or unexpected temporal change (e.g. Central Banks announcements, regulatory changes, corporate earnings announcements, periodic reports of unemployment rates, consumer confidence, geopolitical factors, weather-related news, natural disasters etc.) may influence financial markets stability. As a consequence, the inconsistency of macroeconomic policies with financial stability could fundamentally lead to a decline in financial market integration as a result of global financial market uncertainty, asset price misalignments and divergence in investors sentiment. In a bid to mitigate exposure to market risks, investors commonly adopt the strategy of portfolio diversification.

Generally, diversification is the ideal method of risk reduction if portfolio assets are uncorrelated. The primary aim of international diversification is to enhance the risk-return benefit for investors. For instance, when two stock indices have the same returns, a risk-averse investor will choose the index with the lowest risk. Likewise, an investor will choose a stock index with the highest stock returns when two stock indices have the same risk. Nevertheless, more risk reduction is gained when correlation between assets is low, hence country-specific risk or non-systematic risk can be minimised with international diversification.

A matter of great concern for investors is that portfolio diversification is more difficult when financial markets are integrating rapidly. Therefore, investors may seek to diversify to markets with less integration thereby improving their diversification opportunities. Even though there has been increased in cross-border stock holdings, the tendency for investors to hold a disproportionately share of domestic assets in their portfolio is quiet substantial, thus utmost gains from international diversification is minimised. This puzzle in portfolio choice theory is popularly referred to as equity home bias. The presence of market frictions is adduced in support of equity home bias, which include transaction costs, asymmetric information, portfolio constraints, regulatory barriers and other market imperfections.

Expectedly, market efficiency should improve if portfolio home bias of investors is reduced in a growing integrated financial markets. Consider as an illustration, if investors in search of higher returns with lower risk shift investment to markets that are less efficient, then intense trading activities will compete away the profit opportunities, hence the markets become more efficient and integrated. In tackling this portfolio allocation problem, investors may seek to hedge their overexposure to domestic risk by using foreign stock markets for instance to hedge against adverse price movement, hence reducing systematic or market risk. Accordingly, portfolio allocation decisions and risk-minimising hedging strategies are worth investigating in order to improve our understanding of strategic portfolio management.

In a similar vein, improving profits and assessing market risks have become complicated for many investors in a rapidly changing financial markets. In order to quantify market risk accurately, risk managers consider the use of risk management models such as the value-at-risk measure. The recent global financial crisis reveals the billions of dollars lost by investors as a result of inadequate supervision and management of market risk. Therefore, the exposure of investors to market risk has given more impetus to the growing importance of risk management. In recent times, risk managers use backtesting procedures of market risk estimation to choose the appropriate model for the estimation and to ascertain the accuracy of downside risk of portfolio investment. The quantification of market risk of diversified portfolios has several important implications for international diversification.

Essentially, the evolution of stock market integration basically depends on the phase of development and liquidity of the financial markets. Overall, empirical analysis of market efficiency, market integration, portfolio diversification and risk management would have several salient policy implications that will be relevant to risk managers, portfolio managers, institutional investors, policy-makers and researchers. From the investors perspective, it is important to understand the nature of market efficiency and the role of market integration to properly construct optimal asset allocation, design effective hedging strategy and quantify appropriate the market risk. From the policymakers perspective, it is important to understand the role of shocks and volatility spillovers, as well as drivers of financial integration in order to appropriately calibrate their policy response.

References

Barber, B. and Odean, T. (2001), Boys will be boys: Gender, Overconfidence, and Common

Stock Investment, Quarterly Journal of Economics 116, 261 29.

De Bondt, W., Thaler, R. (1985), Does the stock market overreact? Journal of Finance, 40 (3), 793 805.

Dissanaike, G. (1997), Do Stock Market Investors Overreact? Journal of Business Finance and Accounting, 42(3), 27 50.

Fama, E. (1965a), The Behaviour of Stock Market Prices, Journal of Business, 38: 34 105.

Kahneman, D. and Tversky, A. (1979), Prospect Theory: An Analysis of Decision under Risk, Econometrica 47, 263 91.

Lo, A. (2004), The Adaptive Markets Hypothesis: Market Efficiency from an Evolutionary Perspective, Journal of Portfolio Management, 30: 15 29.

Lo, A. (2005), Reconciling Efficient Market with Behavioural Finance: The Adaptive Markets Hypothesis, Journal of Investment Consulting, 7: 21 -24.

Kim, J., Shamsuddin, A. and Lim, K. (2011), Stock Return Predictability and the Adaptive Markets Hypothesis: Evidence from Century-Long U.S. Data, Journal of Empirical Finance, 18: 868 879.

Urquhart, A. and Hudson, R. (2013), Efficient or Adaptive Markets? Evidence From Major Stock Markets Using Very Long Run Historic Data, International Review Financial Analysis, 28, 130 142.