Applied Finance

Vol.
19
No. 4
Dynamic Relationship Between Futures Trading

and Spot Price Volatility: Evidence from Indian Commodity Market
Ranajit Chakraborty and Rahuldeb Das
Shocks and Herding Contagion in the Oil and Stock Markets
Achraf Ghorbel, Mouna Boujelbene and Younes Boujelbene
October 2013
5
20
Factors Influencing Abnormal Returns Around

Bonus and Rights Issue Announcement
Madhuri Malhotra, M Thenmozhi and Arun Kumar Gopalaswamy
41
Did the Great East Japan Earthquake Have an Impact

on the Market for Long-Term Interest Rates in Japan?
Takayasu Ito
61
Forecasting Daily Stock Volatility Using GARCH Model:

A Comparison Between BSE and SSE
Sasikanta Tripathy and Abdul Rahman
71
The Performance of Initial Public Offerings Based on Their Size:

An Empirical Analysis of the Indian Scenario
L Ganesamoorthy and H Shankar
84
3
IJAF
Vol. 19
No. 4
October 2013
ISSN 0972-5105
EDITOR
E N Murthy
MANAGING EDITOR
GRK Murty
The IUP Journal of Applied Finance is published four

times a year in January, April, July and October.
October 2013. All Rights Reserved.
IJAF is a registered trademark.
No part of this publication may be reproduced or

copied in any form by any means without prior
written permission.
EDITORIAL BOARD
Shyamal K Ghosh
Retired Professor, Indian Institute of Management, Kolkata
IUP holds the copyright to all articles

contributed to its publications.
The views expressed in this publication are purely

personal judgments of the authors and do not
reflect the views of IUP. The views expressed by
external authors represent their personal views
and not necessarily the views of the organizations
they represent.
All efforts are made to ensure that the published

information is correct. IUP is not responsible for
any errors caused due to oversight or otherwise.
CONSULTING EDITOR
J Dennis Rajakumar
P R Joshi
Former Director, UTI Institute of Capital Markets, Mumbai
Kirit Parikh
Former Member, Planning Commission, Government of India
V Raghunathan
CEO, GMR Varalakshmi Foundation
S Sundararajan
Professor of Finance, Indian Institute of Management
Bangalore
R Vaidyanathan
Professor (Finance and Control), Indian Institute of
Management, Bangalore
EDITORIAL TEAM
S V Srirama Rao (Associate Editor)
R Venkatesan Iyengar
T Sri Jyothi
P Manjula
G Swarna
N Durga
Subscriptions
For subscriptions and related enquiries write to:
The Executive, Subscriptions
IUP Publications
(A Division of ICFAI)
# 52, Nagarjuna Hills
Panjagutta, Hyderabad 500082
Andhra Pradesh, India
Ph: +91(40)23430448
E-mail: jms@iupindia.in; info@iupindia.in
Website: www.iupindia.in
Subscription Rates
India
US $
By Post
Send your feedback to

The Editor, IUP Publications
Tel: +91(40)23430448
E-mail: info@iupindia.in
By Courier
1 year
900
40
48
3 years
2400
106
130
5 years
3800
160
200
Payment to be made by crossed Demand Draft drawn

in favor of ICFAI A/c IUP, Hyderabad. Visa and
MasterCard holders can subscribe online or fax their
subscription order indicating their credit card
number, name, amount, expiry date and signature.
Published by E N Murthy on behalf of IUP Publications (A Division of ICFAI), # 52, Nagarjuna Hills,
Panjagutta, Hyderabad 500082, Andhra Pradesh, India, and printed at M/s. Mahathi Print Creations,
2-3-720/A/11, Ganganagar, Amberpet, Hyderabad 500013.
4
The Icfai Journal of Applied Finance, Vol. 14, No. 11, 2008
Dynamic Relationship Between Futures Trading

and Spot Price Volatility: Evidence from
Indian Commodity Market
Ranajit Chakraborty* and Rahuldeb Das**
In this study, an attempt has been made to identify the relationship between the spot price and the level of futures
trading in the Indian commodity market using Granger causality test. For a better explanation of causality, the
procedure of forecast error variance decomposition has been used. The study indicates that for most of the commodities
there is a causal relationship between unexpected futures trading volume and spot price volatility. Furthermore, there
is a weak form of causality between spot price volatility and unexpected futures open interest.
Introduction
In the commodity market, risk and price innovation are managed by commodity derivatives.
To manage the demand and supply of food and raw materials, it is necessary to store them for
future use. This storage activity can be made profitable through forward contract. However,
forward contract results in price risk. So, there is a need for price risk management. Future
contract helps in managing price risk. Since seller/buyer can sell/buy the specified amount of
a commodity at a specified price (called future price) on a specified future date, future contracts
provide insurance to investors regarding the future value of their commodities. To determine
future price, investors compare the current future price to the expected spot price at the
maturity of the contract. This decision is taken based on the demand and supply status of the
commodity. The current future price will be set at a higher level when the maturity of the
contract spot price is expected to be higher relative to the current spot price and vice versa.
Spot and futures markets are closely related and supposed to move together. However,
empirical evidence shows that one market reacts faster to information, while the other reacts
slowly. As a result, a lead-lag relation is observed. Futures trading has some advantages over
the trading of commodity as it has highly liquid market, low margins, leverage position, easily
available short position and rapid execution. Garbade and Silber (1983), Bessembinder and
Seguin (1992), Asche and Guttormsen (2002), Zapata et al. (2005), Karande (2006), and Iyer
and Mehta (2007) reported that future market moves faster than spot market and hence
leads the cash market. The opposite scenario is that the change in the price of the commodity,
for some reason, would be reflected in the subsequent change in the futures price. Silvapulle
and Moosa (1999), and Iyer and Mehta (2007) reported that spot price leads the futures price.
Another cause of price change in the spot market is the level of futures trading. Stein (1987)
*
Professor, Department of Business Management, University of Calcutta, Kolkata, West Bengal, India.
E-mail: ranajit4@hotmail.com
**
Assistant Professor, Department of Basic Science, Techno India College of Technology, Kolkata 700156, West
Bengal, India; and is the corresponding author. E-mail: rahuldeb.das@gmail.com
2013 IUP
. All RightsBetween
Reserved.
Dynamic
Relationship
Futures Trading and Spot Price Volatility: Evidence from Indian
Commodity Market
reported that the amount of speculations in future trading has a greater impact on cash
market volatility.
Figlewski (1981) reported that futures trading and spot price volatility have causality in
both directions. Bessembinder and Seguin (1992) have observed an association between
stock index volatility and the unexpected segment of futures trading. Chen et al. (1995) also
observed a similar type of relationship.
Therefore, one is interested in studying which of the two markets, spot and future, is
disseminating information faster in the Indian scenario. Furthermore, the direction of the
flow of information in the Indian commodity market is another important area of interest.
The mechanism of dissemination of information is important because it influences the spot
and futures prices of the commodities. By studying the dynamic relationship between cash
and futures market, the investors can fix their strategies to gain profit from their investment.
Therefore, in this paper, the authors examine the lead-lag relationship between the spot
price of commodities and the associated futures contract in the Indian market scenario.
Though several works have been done in the financial futures market regarding the relationship
between spot and futures markets, very few efforts have been made to explore the dynamic
relationship between the spot and futures prices in the commodity market. Especially, in a
developing market like India, it is quite relevant to study the relationship between futures
trading and spot price volatility in commodity markets. Zapata et al. (2005) and Bose (2008)
used Granger causality test between spot and futures returns series of indices to find out the
lead-lag relationship for the Indian commodity market. The present study uses Granger
causality test as well as forecast error variance decomposition based on Yang et al. (2005). Sims
(1980) and Abdullah and Rangazas (1988) reported that Granger causality test gives the
statistical significance of economic variables in explaining a dependent variable. However,
to explore the economic significance of a variable in explaining another dependent variable,
forecast error variance decomposition is useful. So, this study offers a better picture of the
relationship between spot and futures market. Moreover, most of the studies in this line have
investigated the volatility of the market before and after introduction of futures trading
because futures market results in additional speculation. According to Stein (1987), the
impact of more or less speculation from established futures trading on spot market volatility
is more relevant than the introduction of the futures market. So, we have examined the effect
of futures trading on the cash price volatility. Further, the paper also examines the causality
between the spot and futures price volatilities of the Indian commodity market.
Literature Review
Several studies have investigated the dynamic relationship between equity futures trading
and spot market returns. However, in commodity markets, we find only a few references.
Figlewski (1981) observed that for GNMA, spot price volatility and futures trading have a
positive contemporaneous relationship. Garbade and Silber (1983) observed that there is a
bidirectional information flow between spot and futures market. Stoll and Whaley (1990)
observed that for equities, futures market leads the spot market in respect of the transmission
6
The IUP Journal of Applied Finance, Vol. 19, No. 4, 2013
of price innovations. Silvapulle and Moosa (1999) observed that new information affects
both the spot and futures market simultaneously. McKenzie and Holt (2002) tested the
market efficiency and unbiasedness for four commodities: live cattle, hogs, corn and soybean
meal. They found that the future market is unbiased in the long run and in the short run it is
inefficient and price-biased. Asche and Guttormsen (2002) observed that for the International
Petroleum Exchange (IPE) in the gas oil contract, future price leads spot price. Giot (2003)
used the skewed student GARCH model to compare the incremental information content
in the collection of agricultural commodities (cocoa, coffee, and sugar future contract) for
lagged implied volatility. They observed that for options on futures contract the conditional
variance and VaR forecast of the underlying future forecast has high information content for
the implied volatility. Zapata et al. (2005), using Granger causality test, found that information
flow is directed from futures prices to cash prices for world sugar on the New York Exchange.
An immediate positive effect on futures and spot prices is observed for any shock in the
futures prices in this market. Yang et al. (2005), using Granger causality test and error variance
decomposition, studied the dynamic relationship of volume and open interest with spot
price volatility for agricultural commodities. They observed that for most commodities,
unexpected positive changes in trading volume increase spot price volatility. For unexpected
open interest, there exists a very weak effect on spot price volatility.
Karande (2006) chose two different markets of the castor seed: export-oriented and
production-oriented, and studied dissemination of information between spot and futures
markets. The study concluded that futures dominates the spot price. Export-oriented market
dominates the production-oriented market except in the harvest season. Praveen and
Sudhakar (2006) compared the price discovery process of the Indian commodity market with
the developed commodity markets. Their study highlighted that futures market influenced
the spot market and facilitated better price discovery in the spot market. The spot and
futures market dominated the price discovery, but it has been observed that a better price
discovery occurred when there was a mature futures market for the commodity. Gupta and
Singh (2006) used price discovery as the main characteristic for judging the efficiency of the
Indian equity futures market. They concluded that futures market leads the spot market in
respect of information flow during the period of high fluctuation. Iyer and Mehta (2007)
found that for chana and copper, future market dominates the spot market in the preexpiration week. For the commodities chana and copper, futures markets have dominated
the spot market in both pre-expiration and expiration weeks. Nickel was the only commodity
for which the spot market plays a dominant role in the pre-expiration and the expiration
weeks. Pati and Kumar (2007) observed that futures trading volume and volatility move in a
similar direction. They concluded that the rate of arrival of information measured by trading
volume and open interest have a strong influence on volatility. But time-to-maturity of a
contract does not have a strong influence on futures volatility. Bose (2008) showed that in
India multi-commodity indices and equity indices have a similar pattern of information flow
and efficiency. Reddy and Sebastin (2008) examined the dynamic relationship between
derivatives market and the underlying spot market. The study observed that price innovations
appeared first in the derivatives market and were subsequently transmitted to the equity
market. They used the concept of entropy to study the information flow between the markets.
Dynamic Relationship Between Futures Trading and Spot Price Volatility: Evidence from Indian
Commodity Market
Thus, most of the empirical findings show that future market provides information to the
spot prices. As a result, futures trading dominates the spot market price. However, there is
some evidence of the flow of information from the spot market to the futures market.
Furthermore, sometimes this causality is bidirectional. The variation is due to the type of the
commodity, the structure of the market, and activities of the market participants.
Data
Data was collected from the website of National Commodity Exchange (NCDEX) in India.
The sample period of the dataset was from June 8, 2005 to May 31, 2010. The data consists of
daily cash closing prices, daily futures settlement prices, total futures trading volume, and
total futures open interest for the agricultural commodities barley, maize, mustard seed and
pepper traded on NCDEX.
Methodology
On the basis of Yang et al. (2005), cash and futures price volatility is modeled as a GARCH(1,1)
process. GARCH process captures the time-varying nature of volatility and models it as
conditional variance. The conditional variance of the error term is expressed as a linear
function of the lagged squared residuals and the lagged residual conditional variance. GARCH
model is also helpful in capturing the volatility clustering feature of financial data. Based on
the Bessembindar and Seguin (1992) procedure, the time series of open interest and futures
trading volume are portioned into expected and unexpected parts. It is assumed that the
information contained in the expected components of futures trading should be reflected in
the cash price. The effect of expected and unexpected components of each trading activity
series is heterogeneous on volatility. The estimated effects of expected activity on volatility
are uniformly smaller than the estimated effects of activity shocks. The unexpected component
of the series is interpreted as the daily activity shock. So, we have considered the unexpected
component of futures trading. We have used 21-day moving average as the expected
components of the futures trading. To calculate the unexpected component of futures trading
volume, expected component of futures trading volume is subtracted from the actual series.
A similar approach is used to calculate the unexpected component of open interest. The
effect of any economic shock can be mitigated by taking 21 days moving average because
almost 21 trading days are there in a month.
The stationarity of each of the series of unexpected Trading Volume (TV), unexpected
Open Interest (OI), Spot price Volatility (SV) and Futures price Volatility (FV) has been
checked by Augmented Dickey-Fuller (ADF) test. Stationarity checking is required, because
regression using a nonstationary series provides unreliable results. To test the dynamic
relationship, we have used bivariate Granger causality test between unexpected futures trading
and cash price volatility. Granger causality test identifies the existence of causality as well as
the direction of causality. Multivariate Granger causality test is applied to know whether
there is a joint effect of unexpected futures trading volume and unexpected open interest on
8
the cash price volatility. Lastly, all the results of Granger causality tests have been confirmed
by the forecast error variance decomposition method. Using Vector Autoregression (VAR)
model, the test expresses the percentage of contribution of a series to explain the variance of
another series. To analyze the effect of futures trading volume and open interest, we consider
SV, TV and OI in the VAR model. However, Bhattacharya et al. (1986) reported that the
futures volatility has a causal influence on spot volatility. So, to make the causality test robust
between futures trading and cash price volatility, a fourth variable FV has been incorporated
into the VAR model. As there is a very poor correlation between FV and TV or FV and OI,
the problem of multicollinearity does not affect the model.
The volatility of spot and futures prices are estimated by GARCH(1,1) model. A model
with errors that follow a GARCH (p, q) process is represented as:
Yt a 0 a1 X t t , t ~ N 0, t2
t2 0
2
i ti
i 1
2
t j
...(1)
...(2)
j 1
Stationarity of all data series has been checked by ADF test. The equation of ADF test is
given below:
Yt bt Yt 1
Y
j
t j
j 1
...(3)
Here t is white noise residuals. If = 0 then there is a unit root. The hypothesis under
consideration is
H0 : b 0
...(4)
Therefore, an F-test is performed on the hypothesis H0. The series contains the unit root,
if the H0 is rejected. If unit root is present in the series, then it is nonstationary.
The causality between unexpected components of futures trading and cash price volatility
is studied to find out which market exerts a stronger influence on the other. Granger causality
test is used for this purpose. This test helps in determining the dynamic relationship between
spot and futures market. To test the Granger causality running from X to Y, the following
equations have been used:
Yt 0
Yt 1
0t
i ti
i 1
p
i ti
i 1
...(5)
X
j
t j
1t
j 1
...(6)
Here 0t and 1t are white noise residuals. In this study, variable values up to lag 5 have been
used. For higher lags, we get similar results. The Granger test, based on Equations (5) and (6),
is equivalent to testing the following null hypothesis:
H 0 : 1 2 3 ... q 0
Commodity Market
...(7)
9
The test statistic for this hypothesis is
SSE1 SSE 2 / q
SSE1 / N p q 1
...(8)
Here SSE1 and SSE2 are the sum of squared errors from the least squared regression in
Equations (5) and (6).
To find whether trading volume and open interest jointly cause the movements in spot
prices, multivariate causality test is implemented. It is an F-type Granger causality test. In
this test, the data series yt is subdivided into y1t and y2t having dimensions K11, and K21,
where K1 + K2 = K. The following is the modified form of VAR(p) using y1t and y2t:
y1t, y2t 11' ,i ,12' ,i | 21' ,i , 22' ,i y1,t i, y2,t i CD t u1t , u 2t

p
i 1
...(9)
If 21,i = , i = 1, 2, , p, then y1t is not a Granger-cause of y2t. The alternative is: there
exists 21,i for i = 1, 2, , p. The test statistic is distributed as F(pK1 K2, KT n* ), with n*
equal to the total number of parameters in the above VAR(p).
But Sims (1972) and (1980), Abdullah and Rangazas (1988) have observed that it will not
be customary to fully rely on the statistical significance of the economic variables determined
by Granger tests. Some variables may not be statistically significant in explaining dependent
variables, but may be economically significant. Therefore, Sims (1980) recommended forecast
error variance decomposition to model the economic variables as it takes care of the economic
significance of the variables. As a result, forecast error variance decomposition provides
some deeper insights than the Granger causality test. The strength of the relationship between
the variables will be more visible in the results of this procedure. The VAR model is of the
following form:
Yt A1 Yt 1 A 2 Yt 2 A 3 Yt 3 ... u t
...(10)
where Yt, having dimension K1 is the vector of variables under study and ut is the disturbance
term of dimension K1. The coefficient matrices A1, , Ap are of dimension KK. The
contribution of the jth variable to the kth variables h-step forecast error variance can be
measured by forecast error variance decomposition procedure. The orthogonalized impulse
response coefficient matrix h is useful for this purpose. The percentage figures are obtained
after dividing the orthogonalized impulse responses by the variance of the forecast error
k2 h . Formally:
k2 h
k 1
2
k1, n
2
k22, n ... kK
,n
...(11)
...(12)
n 0
This can be written as
k2 h
j 0
10
2
kj,0
kj2 , n ... kj2 ,h 1
To calculate forecast error variance decompositions as percentage terms,
kj2 ,0
kj2 , n ... kj2 ,h 1 is divided by k2(h). The forecast error variance decomposition
indicates the extent to which the variation of one economic variable can be explained by
other economic variables in the model.
Empirical Analysis
To estimate the expected component of the futures trading volume and open interest, 21-day
moving averages have been calculated. By subtracting the moving average of futures trading
from its actual value, the unexpected component is extracted. The volatility of spot and
futures prices for different commodities has been estimated from GARCH(1,1) model. The
estimated coefficients of lagged squared residuals and the lagged residual conditional variances
are highly significant for spot (Table 1) and futures (Table 2) prices.
Table 1: Coefficients of GARCH(1,1) Model Used to Estimate Spot Price Volatility
for Different Commodities
Commodity
Barley
Maize
Mustard Seed
Pepper
Coefficients
Estimate
t-Value
Pr(>|t|)
0.000003
0.000000
0.999828
0.615400
8.872000
0.000000
0.780400
39.665000
0.000000
0.111570
3.395000
0.000687
0.267020
4.015000
0.000060
0.575830
5.815000
0.000000
0.025966
4.636000
0.000004
0.157012
7.841000
0.000000
0.827519
43.919000
0.000000
0.009609
8.713000
0.000000
1.000000
10.330000
0.000000
0.018058
0.254000
0.800000
To test whether the spot price volatility, futures price volatility, unexpected futures trading
volume and unexpected futures open interest are stationary, following Bessembinder and
Seguin (1992), ADF test has been used. The test shows that all the series are stationary as the
null hypothesis of existence of unit root has been rejected (Table 3). The p-value in most of
the cases is less than 0.0001.
Then Granger causality test has been used for all commodities between SV and unexpected
component of futures TV. We cannot find any evidence of causality between spot price volatility
and unexpected component of futures trading volume in both the directions for maize. In this
case, the F-test shows insignificant p-values at 5% level (Table 4). On the contrary, mustard
Commodity Market
11
Table 2: Coefficients of GARCH(1,1) Model used to Estimate Futures Price

Volatility for Different Commodities
Commodity
Barley
Maize
Mustard Seed
Pepper
Coefficients
Estimate
t-Value
Pr(>|t|)
0.453520
5.864000
0.000000
0.482670
8.138000
0.000000
0.530940
11.546000
0.000000
0.114940
4.298000
0.000017
0.150450
5.378000
0.000000
0.828440
35.677000
0.000000
0.042050
2.644000
0.008190
0.552220
12.825000
0.000000
0.717920
40.870000
0.000000
1.316070
4.319000
0.000016
0.149900
4.349000
0.000014
0.522700
5.543000
0.000000
seed and pepper show a different scenario. We have found significant causality between spot
price volatility and unexpected component of trading volume. There exists bidirectional Granger
causality between SV and TV. The causality from TV to SV is very strong for these two
commodities, since for all the lags p-values are very small.
Table 3: ADF Test Results for Different Data Series
Commodity
Barley
Maize
Mustard Seed
12
Data Series
ADF Stat.
Lag Order
SV
8.42
12
<0.0001
TV
15.94
12
<0.0001
OI
21.36
12
<0.0001
FV
12.70
12
<0.0001
SV
13.77
12
<0.0001
TV
19.49
12
<0.0001
OI
11.66
12
<0.0001
FV
8.78
12
<0.0001
SV
6.07
12
<0.0001
TV
18.95
12
<0.0001
OI
4.78
12
0.0005
FV
12.02
12
<0.0001
p-Value
Table 3 (Cont.)
Commodity
Pepper
Data Series
ADF Stat.
Lag Order
SV
6.61
12
<0.0001
TV
14.49
12
<0.0001
OI
25.53
12
<0.0001
FV
19.22
12
<0.0001
p-Value
Note: SV = Spot Volatility, TV = Unexpected Trading Volume, OI = Unexpected Open Interest, FV =

Futures Volatility.
From SV to TV, the causality is running for lag 1 and lag 2 only in case of mustard seed. For
pepper, the causality is running in the same direction for lag 4 and lag 5. Again, in the case of
barley, we find unidirectional causality from TV to SV.
Unexpected component of futures OI shows no causality with spot price volatility for the
commodities barley and maize. In both directions, the F-tests are showing insignificant
p-values at 5% level (Table 5). However, for mustard seed and pepper, there is causality in the
direction SV to OI.
Table 4: Granger Causality Test Between Unexpected Component of Futures
Trading Volume (TV) and Spot Price Volatility (SV) for the Commodities
Barley, Maize, Mustard Seed and Pepper
Commodity
Barley
Maize
Mustard Seed
Lag
TV ~ SV
SV ~ TV
Pr(>F)
Pr(>F)
2.9094
0.08838
16.8180
0.0000446
1.1376
0.321
9.6896
0.0000681
0.6522
0.5817
7.0815
0.0001040
0.5982
0.664
5.3380
0.0002969
0.6019
0.6986
5.0320
0.0001473
0.5474
0.45950
0.0906
0.76340
2.4750
0.08451
0.3846
0.68080
1.8266
0.14040
0.2272
0.87750
1.3594
0.24580
0.3899
0.81600
1.1666
0.32340
0.4584
0.80740
7.9613
0.00483300
14.981
0.00011260
4.1744
0.01554000
9.3266
0.00009351
2.3136
0.07420000
9.7454
0.00000224
1.1524
0.33020000
8.1284
0.00000171
0.7726
0.56940000
6.7021
0.00000340
Commodity Market
13
Table 4 (Cont.)
Commodity
Pepper
Lag
TV ~ SV
SV ~ TV
Pr(>F)
Pr(>F)
2.1385
0.14380
64.6890
0.00000
1.5435
0.21390
35.1090
0.00000
0.6655
0.57330
24.2550
0.00000
3.0317
0.01668
19.9270
0.00000
2.3229
0.04091
16.3410
0.00000
Note: The p-values in bold numeric are statistically significant at 5% level.
So, using Granger causality test we find mixed results. For the commodity maize, we do
not find sufficient evidence of Granger causality between the unexpected components of
futures TV and SV, and also between unexpected components of OI and SV. For mustard seed
and pepper, there is an indication of bidirectional causality between TV and SV. There exists
unidirectional causality from OI to SV for these commodities. So, there is an indication of
information flow from the futures market to the spot market for these commodities. There is
a flow of information in the reverse direction as well. Again, in case of barley, we find
Table 5: Granger Causality Test Between Unexpected Component of Futures Open
Interest and Spot Price Volatility for the Commodities Barley, Maize, Mustard Seed
and Pepper
Commodity
Barley
Maize
Mustard Seed
14
Lag
OI ~ SV
SV ~ OI
Pr(>F)
Pr(>F)
0.2626
0.6084000
2.7149
0.0997400
0.1454
0.8647000
1.3971
0.2478000
0.5325
0.6601000
0.8117
0.4875000
0.5885
0.6710000
0.6929
0.5969000
0.6145
0.6888000
0.5156
0.7646000
3.1175
0.07766
0.7922
0.37360
2.8295
0.05936
0.4819
0.61770
1.6680
0.17200
2.0443
0.10580
1.7019
0.14700
1.8803
0.11140
1.5254
0.17880
1.5655
0.16680
4.8589
0.02763000
3.6777
0.05531000
3.528
0.02957000
1.8115
0.16370000
2.2796
0.07760000
1.2595
0.28670000
Table 5 (Cont.)
Commodity
OI ~ SV
Lag
Pepper
SV ~ OI
Pr(>F)
Pr(>F)
2.0048
0.09138000
1.0801
0.36470000
1.7894
0.11180000
1.0332
0.39630000
0.3837
0.53570
1.1855
0.27640
0.5019
0.60550
2.2211
0.10880
2.8059
0.03843
1.5101
0.21000
2.5372
0.03837
2.3542
0.05190
2.3735
0.03708
2.1429
0.05785
Note: The p-values in bold numeric are statistically significant at 5% level.
unidirectional causality from TV to SV. To test whether the trading volume and open interest
together influence the spot market volatility, we use multivariate Granger causality test for
these commodities.
In multivariate Granger causality tests, the effect of both unexpected components of
futures TV and unexpected components of OI is jointly considered. Granger causality in the
direction of futures trading activity to spot market volatility is found for barley, mustard seed
and pepper (Table 6). The F-test shows very small p-values. Hence, the results indicate the
causality running from the futures market to the spot market. There is causality in the
reverse direction also for the commodity mustard seed. However, for pepper, there is no
causality running from spot price volatility to futures trading, and it is contradictory to the
results that have been observed from the Granger causality test. As a result, multivariate
Granger causality test supports the results obtained from the bivariate Granger causality test,
except in the case of pepper.
From bivariate and multivariate Granger causality tests for lead-lag relation between spot
price volatility and futures trading volume, a few points are almost clear. Futures trading
volume does not influence the spot price volatility for the commodity maize. Furthermore,
Table 6: Multivariate Granger Causality test for Barley, Maize,
Mustard Seed and Pepper
Commodities
SV~ TV+ OI
TV+ OI ~ SV
F-Test
df 1
df 2
p-Value
F-Test
df 1
df 2
p-Value
Barley
2.6444
10
2871
0.003285
0.7272
10
2871
0.6995
Maize
1.0775
10
4422
0.3756
1.2196
10
4422
0.2726
Mustard Seed
4.8891
10
5229
0.0000005
1.3615
10
5229
0.0029
Pepper
10.3682
10
5307
0.0000005
2.7749
10
5307
0.1917
Commodity Market
15
the spot price volatility does not cause futures trading volume for this commodity. So, the
lead-lag relationship does not exist between spot and futures market in this case. However,
trading volume causes cash price volatility for barley, mustard seed and pepper. Moreover,
there is causality in reverse direction for the mustard seed. This result of bidirectional causality
is consistent with the findings of Silvapulle and Moosa (1999) on WTI crude oil and Yang
et al. (2005) on sugar. In case of lead-lag relationship between cash price volatility and open
interest, it has been observed that no causality exists in the case of barley and maize. The
causality between cash price volatility and open interest is consistent in both the tests for
mustard seed and contradictory in the two tests for pepper. So, the direction of causality in
Indian commodity markets is commodity-specific. For better inference, we use forecast error
variance decomposition procedure for our data.
The multivariate VAR model provides the forecast error variance decompositions (Tables
7 and 8) of the variables SV, FV, unexpected futures TV and unexpected OI. It has been found
that the percentage of variation in the spot price explained by unexpected trading volume is
2% for Maize (Table 7). However, for barley, mustard seed and pepper, the percentages of
variation in the spot price explained by unexpected trading volume are significantly high up
to 8%, 7% and 14%. These results are consistent with the results of the bivariate Granger
causality test. The percentages of variation in trading volume explained by spot price volatility
are 2% for all commodities (Table 8). Moreover, we have found significant effects of spot price
volatility on unexpected trading volume for the commodities mustard seed and pepper in
Granger causality test. So, in the case of mustard seed and pepper, the results are contradictory
in two tests. Therefore, clearly, the unexpected trading volume has a significant effect on spot
Table 7: 21 Days Forecast Error Variance Decomposition
Commodity
SV Explained by
FV Explained by
SV
FV
TV
OI
SV
FV
TV
OI
Barley
0.76
0.14
0.08
0.02
0.03
0.87
0.07
0.03
Maize
0.90
0.05
0.02
0.03
0.02
0.70
0.07
0.21
Mustard Seed
0.92
0.00
0.07
0.01
0.03
0.87
0.02
0.08
Pepper
0.82
0.03
0.14
0.01
0.05
0.79
0.07
0.09
Table 8: 21 days Forecast Error Variance Decomposition

Commodity
TV Explained by
OI Explained by
SV
FV
TV
OI
SV
FV
TV
OI
Barley
0.02
0.03
0.67
0.28
0.01
0.01
0.04
0.94
Maize
0.02
0.03
0.77
0.18
0.01
0.01
0.01
0.97
Mustard Seed
0.01
0.01
0.78
0.20
0.01
0.02
0.10
0.87
Pepper
0.02
0.02
0.62
0.34
0.01
0.04
0.02
0.93
16
price volatility for the commodities barley, mustard seed and pepper. Therefore, futures market
provides significant information for price discovery to the spot market and hence leads the
spot market. Again, spot price volatility has weak causal feedback on unexpected trading
volume for mustard seed and pepper.
For the commodities under study, the percentage of variation in the spot price explained
by unexpected component of open interest (Table 7) is lying between 1% and 3%. So, there is
lack of influence of unexpected open interest on spot price volatility. Similar results have
been observed for the bivariate Granger causality test also. Again, the percentage of variation
in unexpected open interest explained by the spot price is insignificant for barley, maize,
mustard seed and pepper. For mustard seed and pepper, the results are not consistent with the
Granger test results. Again, we find a weak form of causality running from the futures market
to the spot market. So, the spot market has lesser impact on the movements of the futures
market.
In addition, forecast error variance decomposition method also indicates significant
influence of spot price volatility on futures price volatility for the commodity pepper. On the
other hand, the variation of spot price volatility explained by futures price volatility is up to
14% for barley and 5% for maize.
Conclusion
Using four agricultural commodities from the Indian commodity market, this paper examines
the relation between commodity futures trading and spot price volatility. The study finds
that unexpected trading volume causes spot price volatility for most of the commodities.
This observation is confirmed by Granger causality test and forecast error variance
decompositions. Though bivariate Granger causality test shows information flow from spot
price volatility to unexpected trading volume for a few commodities, no such evidence is
found in forecast error variance decomposition results. Therefore, it can be concluded that
there exists weak causal feedback from spot price volatility to unexpected trading volume. A
similar weak form of causality is observed in the direction of spot price volatility to unexpected
open interest for the same commodities.
These findings are consistent with the findings of Yang et al. (2005), but contradictory to
the findings of Darrat and Rahman (1995) and Iyer and Mehta (2007). So, futures market
dominates the spot market for most of the commodities. The information appears first in the
futures market and then is transmitted down to the spot market. As a result, futures market
enjoys greater leverage which in turn attracts the speculators. Greater speculative activity
provides liquidity to the market and helps in price discovery. There is a weak information
flow from spot market to the futures market for a few commodities. So, spot market also helps
in price innovation of the futures market.
References
1. Abdullah D A and Rangazas P C (1988), Money and the Business Cycle: Another
Look, Review of Economics and Statistics, Vol. 70, No. 4, pp. 680-685.
Commodity Market
17
2. Asche F and Guttormsen A G (2002), Lead-Lag Relationship Between Futures and

Spot Prices, Discussion Paper D-15/2001, Department of Economics and Social Science,
Agricultural University of Norway, available at http://brage.bibsys.no/nhh/bitstream/
URN:NBN:no-bibsys_brage_22418/1/A02_02.pdf
3. Bessembinder H and Seguin P (1992), Futures-Trading Activity and Stock Price
Volatility, Journal of Finance, Vol. 47, No. 5, pp. 2015-2034.
4. Bhattacharya A K, Ramjee A and Ramjee B (1986), The Causal Relationship between
Futures Price Volatility and the Cash Price Volatility of GNMA Securities, Journal of
Futures Markets, Vol. 6, No. 1, pp. 29-39.
5. Bose S (2008), Commodity Futures Market in India: A Study of Trends in the National
Multi-Commodity Indices, Money and Finance, May, pp. 125-158.
6. Chen N, Cuny C J and Haugen A R (1995), Stock Volatility and Levels of the Basis and
Open Interest in Futures Contracts, Journal of Finance, Vol. 50, No. 1, pp. 281-300.
7. Darrat A F and Rahman S (1995), Has Futures Trading Activity Caused Stock Price
Volatility?, Journal of Futures Markets, Vol. 15, No. 5, pp. 537-557.
8. Figlewski C (1981), Futures Trading and Volatility in the GNMA Market, Journal of
Finance, Vol. 25, No. 2, pp. 431-444.
9. Garbade K D and Silber W L (1983), Price Movement and Price Discovery in Futures
and Cash Market, Review of Economics and Statistics, Vol. 65, No. 2, pp. 289-297.
10. Giot P (2003), The Information Content of Implied Volatility in Agricultural
Commodity Markets, Journal of Futures Markets, Vol. 23, No. 5, pp. 441-454.
11. Gupta K and Singh B (2006), Price Discovery Through Indian Equity Futures Market,
The IUP Journal of Applied Finance, Vol. 12, No. 12, pp. 70-83.
12. Iyer V and Metha H (2007), Price Discovery and Convergence in the Indian
Commodities Market: A Two Regime Threshold VAR Approach, paper presented at
the National Workshop on Commodity Research, NCDEX Institute of Commodity
Markets and Research (NICR), available at http://www.nicrindia.com/Pages/
Workshop.aspx
13. Karande K D (2006), A Study of Castorseed Futures Market in India, Indira Gandhi
Institute of Development Research, Mumbai, India, available at http://ssrn.com/
abstract=983342
14. McKenzie A M and Holt M T (2002), Market Efficiency in Agricultural Futures
Markets, Applied Economics, Vol. 34, No. 12, pp. 1519-1532.
15. Pati P C and Kumar K K (2007), Maturity and Volume Effects on the Volatility: Evidences
from NSE Nifty Futures, The IUP Journal of Derivatives Markets, Vol. 4, No. 4, pp. 44-63.
18
16. Praveen D G and Sudhakar A (2006), Price Discovery and Causality in the Indian
Derivatives Market, The IUP Journal of Derivatives Markets, Vol. 3, No. 1, pp. 22-29.
17. Reddy Y V and Sebastin A (2008), Interaction between Equity and Derivatives Markets
in India: An Entropy Approach, The IUP Journal of Derivatives Markets, Vol. 5, No. 1,
pp. 18-32.
18. Silvapulle P and Moosa I A (1999), The Relationship between the Spot and Futures
Prices: Evidence from the Crude Oil Market, Journal of Futures Markets, Vol. 19, No. 2,
pp. 175-193.
19. Sims C (1972), Money, Income and Causality, American Economic Review, Vol. 62,
No. 4, pp. 540-452.
20. Sims C (1980), Macroeconomics and Reality, Econometrica, Vol. 48, No. 1, pp. 1-48.
21. Stein J C (1987), Informational Externalities and Welfare-Reducing Speculation,
Journal of Political Economy, Vol. 95, No. 6, pp. 1123-1145.
22. Stoll H R and Whaley R E (1990), The Dynamics of Stock Index and Stock Index
Futures Returns, Journal of Financial and Quantitative Analysis, Vol. 25, No. 4,
pp. 441-468.
23. Yang J, Baleyat R D and Leatham D J (2005), Futures Trading Activity and Commodity
Cash Price Volatility, Journal of Business Finance and Accounting, Vol. 32, No. 1,
pp. 297-323.
24. Zapata H, Fortenbery T R and Armstrong D (2005), Price Discovery in the World
Sugar Futures and Cash Markets: Implications for the Dominican Republic, Staff Paper
No. 469, Department of Agricultural and Applied Economics, University of WisconsinMadison, available at http://www.aae.wisc.edu/pubs/sps/pdf/stpap469.pdf
Reference # 01J-2013-10-01-01
Commodity Market
19
Shocks and Herding Contagion

in the Oil and Stock Markets
Achraf Ghorbel*, Mouna Boujelbene** and Younes Boujelbene***
This paper presents empirical evidence of herding contagion between oil market and stock markets, during the oil
shock and the US financial crisis period of 2008-2009, after controlling fundamentals-driven comovements. We
estimate the forecasting errors of time-varying parameters using the Kalman filter for oil market and 23 stock markets
of oil importing and oil exporting countries, which are independent of macroeconomic fundamental factors. A sharp
increase in conditional volatility of the forecasting errors is observed in oil market and stock markets during the turmoil
period. To capture the pure contagion effects between oil market and stock markets, we analyze the dynamic correlation
between forecasting errors of oil price returns and stock indices returns. The empirical results show a significant
increase in time-varying correlation coefficients during the oil crisis and the US financial crisis period of 2008-09,
which indicates a strong evidence of herding contagion between oil market and stock markets.
Introduction
The crisis in the US financial market is seen today as one of the biggest financial crises in
history. It was a starting point of severe turbulences in other markets as in the case of the oil
market. During this crisis, investors tended to leave the stock markets by selling their shares
in the process of depreciation. Then, the speculation moved towards the oil market, causing
a price increase. This speculation generated a bubble in the oil market which burst in July
2008. Consequently, both oil and financial markets underwent a period of high volatility
raising the question of contagion and shocks transmission between the two markets during
the turmoil period.
Recent empirical works have studied the volatility spillovers or dynamic correlations
between shocks in crude oil prices and set index prices, and found evidence of increased
correlations between oil market and stock markets during the oil and financial crisis periods
identifying the contagion effect (gren, 2006; Malik and Hammoudeh, 2007; Bharn and
Nikolovann, 2010; Chang et al., 2010; Choi and Hammoudeh, 2010; Cifarelli and Paladino,
2010; Filis, 2010; Sadorsky, 2011; and Ghorbel et al., 2011 and 2012). The literature on
financial contagion is rich as it identifies the contagion channels. Baig and Goldfajn (1999)
and Forbes and Rigobon (2002) defined contagion as a significant increase in cross-market
linkages after an initial shock to one country or a group of countries.
*
Faculty of Economics and Management of Sfax, Laboratory URECA, University of Sfax, Street of Airport,
km 4.5, LP 1088, Sfax 3018, Tunisia; and is the corresponding author. E-mail: ghorbelachraf@yahoo.fr
**
Faculty of Economics and Management of Sfax, Laboratory URECA, University of Sfax, Street of Airport,
km 4.5, LP 1088, Sfax 3018, Tunisia. E-mail: abbes.mouna@gmail.com
*** Professor, Higher Institute of Business Administration of Sfax, University of Sfax, Street of Airport, km 4.5,
LP 1088, Sfax 3018, Tunisia. E-mail: boujelbeneyounes@yahoo.fr
2013 IUP. All Rights Reserved.
20
The objective of this paper is to investigate the existence of herding contagion between
oil and stock markets during the turmoil period of 2008-09. The paper tests the herding
contagion by analyzing the dynamic correlations between the stochastic components of the
oil returns and stock indices returns.
Literature Review
Understanding the causes of contagion effect requires a combination of approaches. Among
these, one approach considers cross-country correlation in measuring contagion. The other
approach, called pure contagion, considers the investor behavior. King and Wadhwani
(1990) employed the first approach in the US, the UK, and the Japanese stock markets and
found evidence of a significant rise in correlations after the crash. Also, Bertero and Mayer
(1990), Hamao et al. (1990), Lee and Kim (1993) and Karolyi and Stulz (1996) reported that
cross-country correlation increased during the same crisis for many financial markets. Calvo
and Reinhart (1996) found evidence of a rise in correlation between weekly returns on
equities and Brady bonds for Asian and Latin American emerging markets after the Mexican
crisis. Baig and Goldfajn (1999) reported the most thorough analysis using cross-country
framework and test for contagion in stock indices, currency prices, interest rates, and sovereign
spreads in emerging markets during the 1997-98 East Asian crisis. They concluded that
contagion occurred during the crisis period as correlations increased significantly during this
period. However, Forbes and Rigobon (2002) rejected the hypothesis that correlation
coefficients between markets increased significantly during the crisis period, leading the
authors to conclude that there was no contagion, only interdependence. Under the second
approach, Pindyck and Rotemberg (1990) and Masson (1998) argued that market sentiments
play a role in explaining comovements of macro-variables among countries. Other studies
consider herding bias in explaining the spillover of financial crisis. Calvo and Reinhart
(1996) and Khan and Park (2009) suggested that herding contagion is principally caused by
factors that are independent of economic fundamentals. Chiang et al. (2007) reported that
the contagion effect took place during the early stage of the Asian financial crisis and that
herding behavior dominated the later stage of the crisis. Khan and Park (2009) found the
existence of herding contagion in the stock markets during the financial crisis of 1997. They
tested the contagion by analyzing the cross-country time-varying correlations among the
stochastic components of the stock prices for Thailand, Malaysia, Indonesia, Korea, and the
Philippines between crisis and tranquil period. Their results showed a significant increase in
residual correlations during the crisis period compared to the tranquil period, after controlling
macroeconomic fundamentals and global shocks.
Recently, new empirical studies have focused on the herding behavior in the financial
markets (Robert and Prechter, 2001; Caparrelli et al., 2004; Blasco and Ferreruela, 2008;
Boyson et al., 2010; and Balcilar et al., 2013).
This paper makes an original contribution in identifying the herding contagion between
oil market and stock markets, especially during the oil shock and the US financial crisis
period of 2008-09. The paper examines whether the dynamic correlation between the returns
21
of oil market and stock markets of oil importing and exporting countries increased during
the oil and financial crises of 2008, after controlling fundamentals-driven factors. The
correlations obtained are expected to better represent market sentiments or herding behavior.
If these correlations are significantly higher than the historical correlations, then we have
reason to believe that market sentiments have shifted. Moreover, using time-varying approach
to study the correlation dynamics can help capture the market sentiments. If herding affects
the behavior of investors during the crisis period, compared to the tranquil period, structural
breaks in the correlation dynamics are expected.
Data
The paper uses monthly data for oil market and 23 stock market indices of oil importing and
exporting countries for the period January 1997 through June 2011. Using Energy
Administration Information (EAI) classification, this study categorizes countries into
importing and exporting countries. Oil exporting countries are Russia, Canada, Norway,
Malaysia, Denmark and Argentina. Oil importing countries are US, UK, France, Italy, Belgium,
Portugal, Greece, Sweden, Germany, Switzerland, the Netherlands, Japan, Hong Kong (HK),
China, Singapore, Thailand and Brazil.
Methodology
In our empirical processes, we mainly conduct an examination through the following models.
First, we use the trivariate BEKK-GARCH model to estimate the volatility spillovers between
oil returns, US index returns and the respective individual stock indices returns of oil
importing and exporting countries. Second, the Kalman filtering, which is a special case of
the general state-space model, is applied for estimating the herding contagion between oil
market and stock markets. Kalman filter is a useful tool for estimating a dynamic system that
involves unobserved state variables. These residuals were obtained by running a Time-Varying
Parameter (TVP) model.
The Trivariate BEKK-GARCH Model

We use a multivariate BEKK-GARCH model of Malik and Hammoudeh (2007) to examine
the volatility spillover between oil market, US stock market and stock markets of oil importing
and oil exporting countries. We start the empirical spillover specification with a trivariate
VAR-GARCH(1, 1) model that accommodates oil price returns, US index returns and the
index returns of each stock market lagged one period. This model is as follows:
rt rt1 t
t / Ft1 ~ N(0, H t )
r1,t
c1
11

rt r2,t , c 2 , 21
r
c
3
31
3,t
22
...(1)
1,t
h11,t
12 13
22 23 , t 2,t , H t h 21,t

h
32 33
3,t
31,t
h12,t
h 22,t
h 32,t
h13,t
h 23,t
h 33,t
...(2)
where r1,t represents the oil future price returns, r2,t US index returns and r3, t the index returns
of each country. The elements 12 and 13 are the degrees of mean spillover effects from the oil
market to the US stock market and the stock markets of other importing and exporting
countries, respectively. The vector of random errors t represents the innovation for each
market at time t with its corresponding conditional variance-covariance matrix Ht. The
market information available at time t 1 is represented by the information set Ft1. The
vector represents the constant.
The h11,t represents the variance of oil future price, h22,t is the variance of the US stock
index and h33,t is the variance of the stock indices. h12,t and h13,t represent the covariance
between oil price and the US stock market and between oil price and stock markets,
respectively. h23,t is the covariance between the US stock index and the stock markets.
Given the above expression, and following Engle and Kroner (1995), the conditional
covariance matrix can be written as:
H t C0 C 0
i 1
A t 1 t1 A i
G H
t 1G i
...(3)
i 1
0
11 0
11 12 13
11 12 13
h1t

C
0 , A 21 22 23 , G 21 22 23 , H t h 2t
...(4)
where 0 21 22

31 32 33
31 32 33
31 32 33
3t
In the variance model, C0, Ai and Gi are 3 3 parameter matrices with C0 being the lower
triangular matrix, where ij are the elements of a symmetric matrix of constants C0; ij, the
elements of the symmetric matrix A, measure the degree of market shocks from market i to
market j; and the elements ij of the symmetric matrix G indicate the persistence in conditional
volatility between market i and market j. For instance, 12 and 13 represent the volatility
spillover from oil market to the US stock market and each stock market, respectively. The
model ensures that the conditional variance-covariance matrices, Ht, is positive definite if at
least one of C0 or G is of full rank. The total number of estimated elements for the variance
equations in our trivariate case is 24.
The conditional variance for each trivariate GARCH(1,1) equation (excluding constants)
can be written as:
h 11,t 11 11 12,t 1 2 12 1,t 1 2,t 1 2 31 1,t 1 3,t 1
2 2
21 21 22,t 1 2 31 2,t 1 3,t 1 31
3,t 1
11 11h11,t 1 212h12,t 1 2 31h13,t 1

2
21 21 h 22,t 1 2 31 h 23,t 1 31
h 33,t 1
...(5)
23
h 22,t 12 12 12,t 1 2 22 1,t 1 2,t 1 2 32 1,t 1 3,t 1
2 2
22 22 22,t 1 2 32 2,t 1 3,t 1 32
3,t 1
12 12 h11,t 1 2 22 h12,t 1 2 32 h13,t 1

2
22 22 h 22,t 1 2 32 h 23,t 1 32
h 33,t 1
h 33,t 13 13 12,t 1 2 23 1,t 1 2,t 1 2 33 1,t 1 3,t 1
...(6)
2
23 23 22,t 1 2 33 2,t 1 3,t 1 33
32,t 1
13 13h11,t 1 2 23h12,t 1 2 33h13,t 1

2
23 23 h 22,t 1 2 33 h 23,t 1 33
h 33,t 1
...(7)
Equations (5), (6), and (7) represent as to how shocks and volatility are transmitted
across markets.
The conditional variance of the trivariate BEKK-GARCH model estimated in this paper
includes three variables: oil returns, US index returns, and the respective individual market
returns of 22 oil importing and exporting countries.
Time-Varying Parameter Model

The Kalman filter is based on the representation of the dynamic system with a state-space
model that consists of the measurement equation that describes the relationship between
observed variables and unobserved state variables, and the transition equation that describes
the dynamics of the state variables. The transition equation has the form of a first-order
difference equation in the state vector. In our empirical framework, we use the time-varying
model of Khan and Park (2009). In this model, each market i has respectively its measurement
equation and transition equation.
The measurement equation of the state-space model is as follows:
S it X it t it , it N(0, 2 )
...(8)
For each stock market i, Sit is the stock index returns observed at time t and time-varying
parameter vectors, the i, are the unobserved state variables that explain the variation of the
change in the stock market returns. Three exogenous variables are considered in this model:
Short-term interest rates (i), industrial production (ip) and exchange rate (ex).
Also, for the oil market, Sit is the oil future price returns and exogenous variables are world
oil supply (Ot), world oil demand (Dt), US-short-term interest rates (iusa), US-industrial
production (ipusa) and US-exchange rate (exusa). The residual, it, is the stochastic error term
for market i.
24
The transition equation is the first-order difference equation that illustrates the evolution
of time-varying state vector:
2
t A t 1 W t , Wt N(0, W
)
...(9)
2
, A is a diagonal matrix
where W is a vector random variable with zero mean and variance W
and the state transition operator which is applied to pervious state t 1.

The model (TVP), given by Equations (8) and (9), estimates the unobserved state variables
t using the Maximum Likelihood Estimation (MLE) method, based on the prediction error
decomposition and the Kalman Filter. The maximized log likelihood function is as follows:
ln L
1
2
ln 2 Ft / t 1
t 1
1
2
'
1
t / t 1 Ft / t 1 t / t 1
t 1
...(10)
where t / t 1 is the prediction error and Ft / t 1 is the conditional variance of the prediction
error. The prediction error is the difference between actual value Mit and the fitted value of
Mit given information up to t1, Mit/t1. So, we obtain:
t / t 1 M it M it / t 1
...(11)
and the conditional variance of the prediction error is calculated as:
Ft / t 1 E t2/ t 1
...(12)
Using the stochastic components of stock indices, we can assess the dynamic structure of
the correlation for contagion. The time-varying correlation coefficients between the
prediction error of oil market and stock index t is as follows:
t t
i
j
...(13)
where t is the coefficient of a regression of i on j which are the stochastic components of oil
market i and stock market for country j, and i and j are the standard deviations of oil market
i and stock market j, respectively.
In the present analysis, for each market index, the regressions were run on a set of
macroeconomic variables, which were chosen for their theoretical and empirical relevance.
Short-term interest rates (usually Treasury-bill rates) are drawn from IFS, IMF and OECD.
For the US, the three-month Treasury-bill rates are drawn from FRED; for the European
countries the industrial production data is drawn from OECD, for the US, it is drawn from
FRED and for Asian and Latin American countries from IFS and IMF. Exchange rates are
drawn from FRED for all the countries, and index prices in US dollars are from MSCI for all
the countries.
25
For each country, index return is defined as the continuously compounded returns on
stock price index. The stock market returns are computed as follows:
rt = ln(pt / pt1)
...(14)
where pt is the index price in month t.

For oil market, the endogenous variable is the return of the West Texas Intermediate
(WTI) crude oil future contract calculated as the continuously compounded returns on oil
future price. The WTI is traded on the New York Mercantile Exchange. It is obtained from
the historical database of the US Department of Energy.
Results and Discussion

The Volatility Spillover
Table 1 reports the BEKK-variance-covariance estimated parameters. The ARCH coefficients
12 and 21 document the presence of shock transmissions between oil market and the US
stock market. Also, the GARCH coefficients 12 and 21 show a strong evidence of significant
transmission of volatility between oil market and the US stock market suggesting a contagion
between oil market and the US stock market during the oil shock and the US financial crisis
of 2008.
The parameters ARCH(13, 31) and/or GARCH(13, 31) are statistically significant for
all oil exporting and importing countries proving the contagion between oil market and
stock markets. In fact, 13 is statistically significant for Norway, Argentina, Russia, Portugal,
Germany, Switzerland, the Netherlands, Hong Kong, China, Thailand and Brazil stock
markets suggesting that oil shocks affect significantly the stock market volatility. By focusing
on GARCH parameters, we show a strong evidence of significant transmission of volatility
(13) from oil market to stock markets for all oil-exporting countries, except for Russia. Also,
volatility shocks are transmitted for most oil-importing stock markets.
The analysis of shock transmissions from stock markets to oil market by 31 shows that
oil market is significantly affected by the stock market shocks of Canada, Belgium, Italy,
Greece, Switzerland, Japan and Hong Kong. From GARCH parameters (31), we show that
there is an evidence of significant transmission of volatility from stock markets of all oilexporting countries to oil market. Also, volatility shocks are transmitted from most oilimporting stock markets to oil market. Moreover, the coefficients (23, 23) indicate a
significant volatility spillover from the US stock market to all stock markets identifying the
contagion of the US subprime crisis to all stock markets. Overall, our results support the
presence of a significant bidirectional volatility transmission between oil and most stock
markets in ARCH and/or GARCH effects.
26
Table 1: Results of the Trivariate GARCH Model

Panel A: Oil Exporting Countries
11
12
13
21
22
23
31
32
33
11
12
13
21
22
Canada
Norway
Russia
Argentina
Malaysia
Denmark
0.02959
0.2554***
0.0268
0.0743
0.2454*
0.0612
(0.296)
(1.89)
(0.237)
(0.532)
(2.86)
(0.425)
0.0175
0.0749
0.2469*
0.0703***
0.0488
0.0214
(0.362)
(1.11)
(4.45)
(1.75)
(0.917)
(0.307)
0.0704
0.2722***
0.2027**
0.242*
0.0385
0.0058
(1.079)
(1.84)
(2.16)
(2.91)
(0.793)
(0.098)
0.9885*
1.0848*
1.0009*
0.522
0.5898*
0.358
(4.14)
(4.13)
(5.57)
(1.32)
(3.32)
(1.44)
0.0615
0.2226***
0.4673*
0.6067*
0.2242**
0.1097
(0.485)
(1.684)
(5.45)
(3.18)
(2.159)
(0.914)
0.295
0.1383
0.3567***
0.0211
0.2026*
0.7256*
(1.55)
(0.559)
(1.73)
(0.065)
(2.62)
(5.1)
0.3002***
0.201
0.0674
0.1086
0.0727
0.1971
(1.859)
(1.607)
(1.29)
(0.428)
(0.809)
(0.876)
0.3664*
0.0767
0.0096
0.253**
0.1794*
0.3687*
(4.806)
(1.39)
(0.43)
(2.105)
(3.29)
(3.946)
0.6308*
0.2683**
0.338*
0.1365
0.3756*
0.8059*
(4.853)
(2.36)
(5.216)
(0.636)
(5.72)
(6.877)
0.6957*
0.1195
0.3467
0.0201
0.7229*
0.3128
(5.41)
(0.549)
(1.36)
(0.11)
(4.06)
(1.475)
0.248*
0.2962*
0.1753*
0.2204*
0.2358*
0.3774*
(5.71)
(4.459)
(3.707)
(2.93)
(3.16)
(4.279)
0.5014*
0.3835*
0.1834
0.5094*
0.1064**
0.514*
(8.69)
(2.65)
(1.23)
(3.26)
(1.992)
(3.74)
0.7181*
0.3949
0.318
1.472*
0.5929*
0.715*
(5.81)
(1.218)
(1.16)
(3.24)
(4.64)
(1.96)
0.7527*
0.885*
0.645*
0.7848*
0.7631*
0.9009*
(159.3)
(8.628)
(9.66)
(4.606)
(8.009)
(5.829)
27
Table 1 (Cont.)
23
31
32
33
Canada
Norway
Russia
Argentina
Malaysia
Denmark
0.1051*
0.2044*
0.3723**
0.327**
0.0355
0.0057
(6.35)
(2.862)
(2.39)
(1.996)
(0.398)
(0.024)
1.043*
0.5647*
0.008**
1.141*
0.1375**
0.5167***
(7.55)
(3.057)
(1.99)
(3.04)
(2.45)
(1.877)
0.0048
0.0777
0.0502*
0.0324
0.0603
0.5455*
(0.158)
(1.126)
(3.21)
(0.288)
(1.47)
(3.91)
0.5314*
0.4166*
0.9591*
0.479**
0.899*
0.1043
(7.01)
(2.751)
(29.02)
(2.54)
(26.28)
(0.498)
Panel B: Oil Importing Countries

UK
France
Germany
Belgium
Italy
Sweden
Portugal
Greece
0.192**
0.0551
0.0743
0.218**
0.5079*
0.4606*
0.2893*
0.4433*
(2.014)
(0.449)
(0.532)
(2.2)
(4.56)
(4.56)
(2.61)
(4.53)
0.0214
0.025
0.073***
0.067***
0.0719
0.0275
0.0218
0.0582
(0.47)
(0.44)
(1.75)
(1.88)
(1.188)
(0.43)
(0.334)
(0.936)
0.0061
0.0585
0.2425*
0.0455
0.045
0.0592
0.183***
0.1329
(0.118)
(0.796)
(2.91)
(0.734)
(0.497)
(0.417)
(1.809)
(1.052)
21 0.4118*** 0.4844**
0.5229
0.0916
0.7059
0.069
0.5292**
0.2572
(3.54)* (0.332)
(2.29)
(1.27)
11
12
13
22
(1.758)
(1.98)
(1.32)
(0.312)
0.0607
0.4644*
0.6067
0.4172*
0.0821
0.194***
0.0247
0.0864
(0.342)
(2.82)
(3.184)
(5.01)
(0.58)
(1.75)
(0.194)
(0.778)
23 0.4763** 1.0706*
(2.44)
31
11
28
0.0211
0.4679*
(0.065)
(3.6)
(0.486)
0.0944 0.6689*
0.4532**
0.6233*
(3.58)
(2.03)
(2.809)
0.2902
0.0446
0.1086
0.313**
0.7829*
0.124
0.1766
0.2384*
(1.15)
(0.1427)
(0.428)
(2.098)
(5.271)
(1.097)
(0.99)
(2.728)
0.6293*
0.2532**
0.0275
0.2589*
0.0289
0.397*
0.1159**
(2.08)
(4.176)
(2.105)
(0.51)
(2.863)
(0.474)
(3.99)
(2.12)
0.6271*
1.1068*
0.1365
0.3962*
0.5339* 0.3086**
0.2776*
0.455*
(3.44)
(6.193)
(0.636)
(3.99)
(4.405)
(2.49)
(1.774)
(4.49)
0.1059
(0.83)
0.0106
(0.038)
0.0201
(0.11)
0.574*
(3.18)
0.0283
(0.195)
0.6559*
(5.106)
0.4052**
(2.37)
0.5854*
(4.519)
32 0.3421**
33
(5.46)
Table 1 (Cont.)
12
13
21
22
23
31
UK
France
Germany
Belgium
Italy
Sweden
Portugal
Greece
0.374*
0.4858*
0.2204*
0.1001
0.215*
0.1613*
0.1822***
0.313*
(6.094)
(11.24)
(2.93)
(1.01)
(3.41)
(3.059)
(1.95)
(4.55)
0.5253*
0.5371*
0.5094*
0.259**
0.267*
0.5095*
0.5764*
0.6528*
(11.01)
(4.403)
(3.26)
(1.98)
(2.725)
(5.11)
(5.52)
(5.348)
0.6919
0.163
1.472*
0.412***
0.4844
0.429**
(1.107)
(0.332)
(3.246)
(1.92)
(2.14)
(1.92)
(1.18)
(1.98)
1.1263*
0.4249
0.7848*
0.941*
0.8707*
1.2218*
0.204
0.8401*
(7.91)
(1.35)
(4.606)
(23.2)
(12.06)
(11.27)
(0.65)
(8.108)
0.4168*
0.68***
0.327*
0.025
(16.33)
(1.811)
(2.167)
(0.26)
1.541*
0.8881*
1.1413*
0.5703**
(2.97)
(3.054)
(3.043)
(2.14)
0.2403
0.0324
0.0705
(1.75)
(1.181)
(0.288)
0.286
0.438***
(1.45)
(1.722)
32 0.635***
33
0.526** 0.3118***
0.109** 0.9415*
0.7625**
0.246
(2.012)
(1.069)
0.0046 0.372***
0.2722
0.2501*
(0.026)
(0.98)
(2.72)
0.0595 0.2713*
0.374
0.1634*
(1.43)
(1.53)
(2.87)
(1.57)
(3.52)
0.479*
0.7349*
0.905*
0.2109
0.1639
0.574*
(2.544)
(6.64)
(19.25)
(1.03)
(0.64)
(6.39)
China
Thailand
(1.99)
(3.674)
(1.92)
Panel B: Oil Importing Countries (Cont.)

Switzerland
11 0.156***
12
Brazil
HK
Singapore
0.0703
0.0677
0.1812
0.0664
0.0677
0.1014
0.0469
(0.721)
(0.808)
(1.167)
(0.734)
(0.721)
(1.013)
(0.42)
0.0093
(0.279)
0.1111*
(2.804)
0.0473
(1.182)
0.08**
(1.996)
0.1716*
(2.801)
0.1777*
(2.808)
0.113***
(1.958)
0.1604*
(3.56)
(2.39)
0.1777*
(3.81)
0.0152
(0.307)
0.2308**
(2.36)
0.246**
(2.52)
0.1271
(1.557)
0.168***
(1.91)
0.1863**
(2.23)
0.144
(0.429)
0.2449
(0.734)
0.3175***
(1.828)
0.8627*
(3.88)
0.6363* 0.383***
(3.82) (1.757)
0.88001*
(4.35)
0.6943*
(3.01)
(5.23)
0.0081
(0.076)
0.0697
(0.728)
0.369*
(3.57)
0.4157*
(3.501)
0.6134*
(5.75)
0.212***
(1.87)
0.5786*
(5.64)
0.931*
(5.85)
0.679*
(5.09)
0.015
(0.126)
0.409
(1.55)
0.385** 0.427**
(2.19) (2.218)
0.387***
(1.81)
0.6811*
(3.09)
22 0.5464*
23
Japan
(1.7)
13 0.089**
21
Netherlands
29
Table 1 (Cont.)
31
32
33
11
Switzerland
Netherlands
Japan
Brazil
HK
0.422**
0.2319
0.3952**
0.088
0.182***
(1.96)
(1.042)
(2.43)
(0.96)
0.7535*
0.1667**
0.2948*
(7.24)
(2.49)
0.9281*
China
Thailand
0.0813
0.044
0.0311
(1.91)
(0.707)
(0.56)
(0.372)
0.0095
0.0049
0.159*
0.1498*
0.1561*
(2.985)
(0.27)
(0.04)
(2.36)
(3.66)
(4.11)
0.5878*
0.207
0.3384*
0.1173
0.2038**
0.5468*
0.1286
(7.55)
(6.38)
(1.496)
(4.084)
(0.806)
(2.188)
(6.03)
(1.56)
0.554*
0.5407*
0.2294*
0.264
0.4264*
0.313
0.072*
0.2228
(3.71)
(3.49)
(2.806)
(1.308)
(5.115)
(0.857)
(0.303)
(1.09)
0.232*
0.1705**
0.0193
0.0322
0.3607*
0.308*
0.3138*
(3.26)
(2.01)
(0.15)
(0.284)
(3.7)
(4.99)
(3.28)
0.0646
0.5433*
0.174
0.5404*
0.069
0.419*
0.1222
(0.54)
(11.55)
(0.609)
(3.56)
(0.358)
(3.009)
(0.611)
1.157*
0.959**
1.099*
1.462*
0.188
0.9393*
12 0.0104***
(0.176)
13 0.2062***
(1.82)
21
0.4311** 0.7234***
Singapore
(1.994)
(1.718)
(4.55)
(2.54)
(3.753)
(3.29)
(0.86)
(2.96)
0.4977*
1.3675*
0.4411*
0.4106*
0.1417
0.5911
0.783*
0.0601
(4.46)
(11.59)
(3.608)
(3.46)
(0.4703)
(1.59)
(6.238)
(0.287)
23 0.471*** 1.6507*
0.5989*
1.0346*
0.5732
0.9946*
0.0731
1.557*
(7.22)
(4.03)
(1.31)
(2.83)
(0.38)
(5.6)
22
31
32
33
(1.91)
(11.34)
0.5101
0.8457*
0.2173
0.202***
(1.07)
(2.63)
(0.708)
(1.96)
(4.82)
(1.964)
(1.996)
(1.978)
0.338*
0.704*
0.8105*
0.2301*
0.5419*
0.6016*
0.1211*
0.284*
(3.18)
(7.912)
(8.104)
(5.59)
(4.65)
(5.69)
(3.09)
(7.28)
0.859*
0.3822
0.206**
1.162*
0.0479
1.135*
0.7538*
0.968*
(4.4)
(3.033)
(2.03)
(14.59)
(0.212)
(8.027)
(9.14)
(16.73)
0.7755* 0.1528*** 0.114**
0.097***
Note: Figures in parentheses are t-values; *, **, *** indicate significance at 1%, 5%, and 10% levels, respectively.
The results of estimated mean equation and constants of each variance equation are not reported for the
sake of brevity.
Herding Contagion Between Oil Market and Stock Markets

Statistical Analysis of Forecasting Errors of Time-Varying Parameters
Table 2 reports the summary statistics for monthly returns on the WTI crude oil future
returns and 23 stock market returns. Generally, oil market and most of the stock markets
30
Table 2: Descriptive Statistics

Panel A: Oil Market and Oil-Exporting Countries
Oil Market
Canada
Norway
Russia
Mean (%)
0.5059
4.81E-03
5.42E-03
4.17E-03
5.87E-08
Median (%)
0.2321
0.0688
0.0615
0.3451
0.1211
0.0299
0.0732
Maximum
0.2420
0.0204
0.0290
0.0927
0.0469
0.0520
0.0259
Minimum
0.3024
0.0346
0.0558
0.1370
0.0696
0.0462
0.0376
8.04
0.93
1.21
2.30
1.75
1.33
0.88
Skewness
0.3498
0.7309
0.8105
1.3512
0.6331
0.0552
0.8075
Kurtosis
3.8018
4.1964
5.8801
11.194
4.6454
5.5415
5.1384
J-B
8.0698
25.425
77.831
530.47
30.716
46.112
51.169
Germany
Belgium
Italy
Sweden
7.07E-04 3.6E-10
1.96E-04
SD (%)
Argentina Malaysia Denmark

3.02E-03 1.42E-03
Panel B: Oil Importing Countries

US
UK
Mean (%)
0.5373
8.37E-08
Median (%)
1.5649
0.0417
0.1152
0.1596
0.1366
0.1335
0.0258
Maximum
0.1319
0.0187
0.0243
0.0295
0.0245
0.0265
0.0312
Minimum
0. 4383
0.0239
0.0309
0.0339
0.0458
0.0375
0.0346
9.448
0.6776
0.907
1.033
0.9853
1.114
1.15
1.001
0.1211
0.6130
0.5380
1.2212
0.5601
0.2839
4.659
3.9086
4.2485
4.1819
7.4387
3.4182
3.7259
48.746
6.3377
21.944
18.310
182.88
10.246
6.0889
SD (%)
Skewness
Kurtosis
J-B
France
5.5E-11 2.04E-12
Markets
Switzerland
Netherlands
Greece
Portugal
Japan
Mean (%)
8.2E-12
5.9E-14
5.8E-12
1.48E-03
6.12E-04
Median (%)
6.90E-03
0.0962
0.2061
0.0994
5.31E03
Maximum
0.0241
0.0254
0.0402
0.0257
0.0249
Minimum
0.0311
0.0314
0.0554
0.0348
0.02
0.7668
0.927
1.435
0.9549
0.8202
Skewness
0.0706
0.5717
0.4377
0.3789
0.3109
Kurtosis
4.9449
4.1068
4.3526
3.7293
3.2268
J-B
27.251
18.150
18.606
7.8832
7.1220
SD (%)
31
Table 2 (Cont.)
HK
China
Thailand
Singapore
Brazil
Mean (%)
0.1156
3.22E-10
1.62E-13
4.13E-03
2.66E-13
Median (%)
0.0568
0.1354
0.1579
0.0302
0.1483
Maximum
0.0293
0.0858
0.0738
0.0468
0.0607
Minimum
0.0518
0.0496
0.0585
0.0335
0.0751
SD (%)
1.2076
1.6903
2.0376
1.3161
1.8643
Skewness
0.4791
0.7748
0.0075
0.4176
0.4346
Kurtosis
4.4420
6.7054
4.2141
4.5459
4.7583
J-B
21.359
114.94
10.504
21.997
27.413
Note: SD is the Standard Deviation and J-B is the Jarque-Bera test.
have mean negative forecasting errors, except for Portugal, Belgium, China, Singapore, Thailand,
Brazil, Switzerland, the Netherlands, Canada, Russia, Malaysia, Norway, Argentina and Denmark
which have positive forecasting errors. All the markets have kurtosis values higher than three.
We also observe that the distribution of returns is negatively skewed for a majority of the
countries, except for Japan, China and Singapore. Therefore, the assumption of Gaussian
forecasting errors is rejected by the Jarque-Bera test for oil and stock market returns.
Figure 1 shows the forecasting errors which are the residual terms of Equation (8) in the
oil market. We observe that the oil return residuals are stationary and present a higher degree
of volatility primarily during the oil crisis period of 2008, while recording a sharp decrease.
Figure 1: Forecasting Errors of Time-Varying Parameter Estimation in Oil Market
0.3
0.2
0.1
0
0.1
0.2
0.3
0.4
1998
2000
2002
2004
2006
2008
2010
Figure 2 shows the forecasting errors in stock market returns after controlling
macroeconomic fundamentals-driven comovements, referring to the part of returns explained
by investors behaviors. The graphs indicate that the residual of indices returns of 23 oil
32
Figure 2: Forecasting Errors of Time-Varying

Parameter Estimation in Stock Markets (1998-2010)
Canada
Norway
Sweden
US
Italy
Switzerland
Greece
Russia
Argentina
Malaysia
Denmark
UK
France
Germany
Belgium
The Netherlands
Japan
China
HK
Portugal
Thailand
Singapore
Brazil
importing and exporting countries are stationary and they showed enhanced volatility during
the financial crisis periods.
The Conditional Volatility of Forecasting Errors of Time-Varying Parameters

Figure 3 depicts the conditional volatility of forecasting errors in oil market. We observe an
increase in the forecasting error volatility, until it reached a peak during the oil crisis and US
financial crisis period of 2008-09. This high degree of volatility is explained by the herding
behavior of the investors in the oil market.
Figure 3: Conditional Volatility of Forecasting Errors in Oil Market
0.020
0.018
0.016
0.014
0.012
0.010
0.008
0.006
0.004
1998
2000
2002
2004
2006
2008
2010
33
Figure 4 shows the forecasting error volatilities in stock markets of oil importing and oil
exporting countries. In fact, the volatility increased significantly during the crisis period
Figure 4: Conditional Volatility of Forecasting Errors in Stock Markets (1998-2010)
Canada
Norway
Malaysia
Denmark
Argentina
US
UK
France
Germany
Belgium
Italy
Sweden
Switzerland
The Netherlands
Japan
Greece
HK
China
Thailand
34
Russia
Singapore
Portugal
Brazil
compared to the tranquil period. Figure 4 indicates high forecasting error volatility during
the crisis periods specific to that country (Russian crisis in 1998, Brazilian crisis in 1999,
Argentine crisis in 2002, etc.). Also, a high volatility was observed during the financial crisis,
characterized by the contagion effect, which affected several stock markets such as East
Asian financial crisis in 1997, technological crisis in 2000 and the 2008 financial crisis.
Indeed, the volatility increased for several stock markets (Greece, UK, US, France, Germany,
Belgium, Italy, Switzerland, Portugal, Sweden, the Netherlands and Japan) after the
technological crisis of 2000. Also, the forecasting errors volatility in Asian stock markets
(Hong Kong, Singapore, China, Malaysia and Thailand) increased after the East Asian
financial crisis in 1997, which confirms the results of Khan and Park (2009), suggesting a
herding contagion between Asian stock markets during the East Asian crisis.
The graphs record a high level of forecasting errors volatility for the period 2008-09,
identifying the volatilities of stock markets which are explained by the investors herding
behaviors in the 2008 financial crisis.
The Dynamic Correlation Between Forecasting Errors of Oil and Stock Markets
Figure 5 shows the time-varying correlation between forecasting errors of oil returns and
stock markets returns of oil exporting and oil importing countries, calculated by using
Equation (13). The graphs in Figure 5 show that the correlations increased, until they reached
Figure 5: Time-Varying Correlation Coefficients Between Forecasting Errors
of Oil Returns and Stock Markets Returns (1998-2010)
Canada
Malaysia
France
Norway
Denmark
Germany
Russia
US
Belgium
Argentina
UK
Italy
35
Figure 5 (Cont.)
Switzerland
Sweden
HK
China
Thailand
Japan
The
Netherlands
Greece
Portugal
Brazil
Singapore
a peak during 2008-09, characterized by the occurrence of oil shock and the US financial
crisis. This finding provides a strong evidence in favor of herding contagion between oil
market and stock markets, and so does the pure contagion between the two markets.
Figure 6 shows the conditional volatilities of time-varying correlation coefficients
computed using Equation (12). There are regime shifts in the correlations concurrently with
the turmoil period of 2008-09. Indeed, the conditional volatility of dynamic correlation
between forecasting errors of oil returns and stock market returns for each oil exporting and
oil importing country increased during the 2008 oil shock and the global financial crisis.
Figure 6: Conditional Volatilities
of Time-Varying Correlation Coefficients (1998-2010)
Canada
36
Norway
Russia
Argentina
Figure 6 (Cont.)
Malaysia
Denmark
France
Germany
Sweden
Switzerland
China
Belgium
HK
Thailand
UK
US
Singapore
Italy
The Netherlands
Japan
Greece
Portugal
Brazil
Conclusion
The empirical framework used in this paper investigates the existence of herding contagion
between oil and stock markets, especially during the oil shock and the US financial crisis
period of 2008-09. Using a trivariate BEKK-GARCH model, we find a strong evidence of
bidirectional volatility transmission between oil market and stock markets of oil importing
37
and oil exporting countries in ARCH effect and/or in GARCH effect. To explain this result,
we consider the herding bias. Using the Kalman filter, we estimate the residual dynamic
correlations between oil returns and stock market index returns after controlling for macrofundamentals. The residuals are expected to filter the effects of standard macro-variables and
may be more effective in identifying the pure contagion. A significant increase of forecasting
errors volatility in oil and stock markets is noted during the turmoil period compared to the
tranquil period. The analysis of the time-varying correlation coefficients between the oil
market and the stock markets of oil importing and oil exporting countries shows an increase
in residual correlations during the oil crisis and the US financial crisis period of 2008-09.
In addition, there are regime shifts in the correlations concurrently with the turmoil period.
This finding suggests that herding behavior can explain, in part, the contagion between
stock markets and oil market during a period of turbulence. Overall, the results of this paper
are important for developing asset pricing models, including herding effect to predict future
equity and oil price return volatility.
References
1.
gren M (2006), Does Oil Price Uncertainty Transmit to Stock Markets?, Working
Paper No. 23, Uppsala University.
2.
Baig T and Goldfajn I (1999), Financial Market Contagion in the Asian Crisis, IMF
Working Paper No. 46, pp. 167-195.
3.
Balcilar M, Demirer R and Hammoudeh S (2013), Investor Herds and RegimeSwitching: Evidence from Gulf Arab Stock Markets, Journal of International Financial
Markets, Institutions & Money, Vol. 23, No. 1, pp. 295-321.
4.
Bertero E and Mayer C (1990), Structure and Performance: Global Interdependence

of Stock Markets Around the Crash of October 1987, European Economic Review,
Vol. 34, No. 6, pp. 1155-1180.
5.
Bharn R and Nikolovann B (2010), Global Oil Prices, Oil Industry and Equity Returns:
Russian Experience, Scottish Journal of Political Economy, Vol. 57, No. 2, pp. 169-186.
6.
Blasco N and Ferreruela S (2008), Testing Intentional Herding in Familiar Stocks: An

Experiment in an International Context, Journal of Behavioral Finance, Vol. 9, No. 2,
pp. 72-84.
7.
Boyson N M, Stahel C W and Stulz R M (2010), Hedge Fund Contagion and Liquidity
Shocks, The Journal of Finance, Vol. 65, No. 5, pp. 1789-1816.
8.
Calvo S and Reinhart C (1996), Capital Flows to Latin America: Is there Evidence of
Contagion Effect?, in G A Calvo, M Goldstein and Eduard Hochreiter (Eds.), Private
Capital Flows to Emerging Markets After the Mexican Crisis, Institute for International
Economics, Washington DC.
38
9.
Caparrelli F, DArcangelis A M and Cassuto A (2004), Herding in the Italian

Stock Market: A Case of Behavioral Finance, Journal of Behavioral Finance, Vol. 5,
No. 4, pp. 222-230.
10.
Chang C L, McAleer M and Tansuchat R (2010), Conditional Correlations and

Volatility Spillovers Between Crude Oil and Stock Index Returns, Kyoto Institute of
Economic Research, KIER Discussion Paper Series 715.
11.
Chiang T C, Jeon B N and Li H (2007), Dynamic Correlation Analysis of Financial

Contagion: Evidence from Asian Markets, Journal of International Money and Finance,
Vol. 26, No. 7, pp. 1206-1228.
12.
Choi K and Hammoudeh S (2010), Volatility Behavior of Oil, Industrial Commodity

and Stock Markets in a Regime-Switching Environment, Energy Policy, Vol. 38, No. 8,
pp. 4388-4399.
13.
Cifarelli G and Paladino G (2010), Oil Price Dynamics and Speculation: A Multivariate
Financial Approach, Energy Economics, Vol. 32, No. 2, pp. 363-372.
14.
Engle R and Kroner K (1995), Multivariate Simultaneous Generalized ARCH,

Econometric Reviews, Vol. 11, No. 1, pp. 122-150.
15.
Filis G (2010), Macro Economy, Stock Market and Oil Prices: Do Meaningful
Relationships Exist Among Their Cyclical Fluctuations?, Energy Economics, Vol. 32,
No. 4, pp. 877-886.
16.
Forbes K and Rigobon R (2002), No Contagion, Only Interdependence: Measuring

Stock Market Co-Movement, Journal of Finance, Vol. 57, No. 5, pp. 2223-2261.
17.
Ghorbel A, Abbes M B and Boujelbene Y (2011), Oil Price Shocks and Financial
Stock Markets, Journal of Applied Research in Finance, Vol. III, No. 2, p. 6.
18.
Ghorbel A, Abbes M B and Boujelbene Y (2012), Volatility Spillovers and Dynamic

Conditional Correlation Between Crude Oil and Stock Market Returns, International
Journal of Managerial and Financial Accounting, Vol. 4, No. 2, pp. 177-194.
19.
Hamao Y, Masulis Y and Ng V (1990), Correlation in Price Changes and Volatility

Across International Stock Markets, Review of Financial Studies, Vol. 3, No. 2, pp. 281307.
20.
Hammoudeh S, Bhar R and Thompson M A (2010), Re-Examining the Dynamic

Causal Oil-Macroeconomy Relationship, International Review of Financial Analysis,
Vol. 19, No. 4, pp. 298-305.
21.
Karolyi G A and Stulz R M (1996), Why Do Markets Move Together? An Investigation

of US-Japan Stock Returns Co-Movements, Journal of Finance, Vol. 51, No. 1,
pp. 951-986.
39
22.
Khan S and Park K W (2009), Contagion in the Stock Markets: The Asian Financial
Crisis Revisited, Journal of Asian Economics, Vol. 20, No. 5, pp. 561-569.
23.
King M and Wadhwani S (1990), Transmission of Volatility Between Stock Markets,

Review of Financial Studies, Vol. 2, No. 3, pp. 5-33.
24.
Lee S B and Kim K J (1993), Does the October 1987 Crash Strengthen the
Co-Movements Among National Stock Markets?, Review of Financial Economies,
Vol. 3, No. 1, pp. 89-102.
25.
Malik S and Hammoudeh S (2007), Shock and Volatility Transmission in the Oil,
US and Gulf Equity Markets, International Review of Economics and Finance, Vol. 16,
No. 3, pp. 357-368.
26.
Masson P (1998), Contagion: Monsoonal Effects, Spillovers, and Jumps Between

Multiple Equilibria, Working Paper No. 98/142, IMF.
27.
Pindyck R and Rotemberg J (1990), The Excess Co-Movement of Commodity Prices,

Economic Journal, Vol. 100, No. 4, pp. 1173-1189.
28.
Robert R and Jr. Prechter (2001), Unconscious Herding Behavior as the Psychological
Basis of Financial Market Trends and Patterns, Journal of Behavioral Finance, Vol. 2,
No. 3, pp. 120-125.
29.
Sadorsky P (2011), Correlations and Volatility Spillovers Between Oil Prices and the
Stock Prices of Clean Energy and Technology Companies, Energy Economics, Vol. 34,
No. 1, pp. 248-255.
Reference # 01J-2013-10-02-01
40
Factors Influencing Abnormal Returns Around

Bonus and Rights Issue Announcement
Madhuri Malhotra*, M Thenmozhi** and Arun Kumar Gopalaswamy***
This paper examines the factors influencing abnormal returns around bonus and rights issue announcements. The
results of the study indicate that market condition and type of industry have significant influence on abnormal returns
and the bonus ratio does not have any significant effect on abnormal returns. For rights announcement, issue size and
market conditions have a significant impact on returns. Firm size, operating leverage, debt-equity ratio and volatility
of stock returns are the other firm-related factors that have a significant impact on stock returns around bonus
announcement. But for rights issue, only firm size is the significant firm-related factor which has a positive impact on
the returns.
Introduction
The changes in abnormal returns of a security around event announcement may be due to
event-induced, firm-specific or event-related factors. There are a host of studies that have
looked into factors that influence stock returns for seasoned issue announcements (Asquith
and Mullins, 1986; Mikkelson and Partch, 1986; and Kalay and Shimrat, 1987). However,
Barclay et al. (1990) have found that there exists a relationship between announcement
effect on abnormal returns and the issuing firms information asymmetry, profitability, growth,
and the issue characteristics. An analysis of factors affecting abnormal returns around the
announcement of new equity issue is important for the following reasons: (1) unrecorded
goodwill may be reflected in the stock price which is not captured by the event itself;
(2) managers have superior information about investment projects compared to investors;
and (3) the issuing firms current financial structure and the impact of new equity issued on
its financial situation are also important factors considered by investors in their valuation of
equity offerings. Though empirical work has focused on examining the significance of the
change in abnormal returns, studies exploring the extent of influence of firm-specific or
event-related factors on abnormal returns are limited.
The literature shows that issue size has a mixed impact on the firms abnormal returns
(Hess and Bhagat, 1986; Abhayankar and Dunning, 1999; Marsden, 2000; Bigelli, 2002; Kato
and Tsay, 2002; Tan et al., 2002; and Wu et al., 2005). A positive relationship between premarket condition and a firms abnormal returns has been documented by Choe et al. (1993),
*
Assistant Professor, Madras School of Economics, Gandhi Mandapam Road, Kottur, Chennai 600025,
Tamil Nadu, India. E-mail: madhurimalhotra@gmail.com
**
Professor, Department of Management Studies, Indian Institute of Technology Madras, Chennai 600036,
Tamil Nadu, India. E-mail: mtm@iitm.ac.in
*** Associate Professor, Department of Management Studies, Indian Institute of Technology Madras, Chennai
600036, Tamil Nadu, India. E-mail: garun@iitm.ac.in
2013 Influencing
IUP. All Rights
Reserved.
Factors
Abnormal
Returns Around Bonus
and Rights Issue Announcement
41
Tsangarakis (1996) and Tan et al. (2002). Different firm characteristics have a significant
effect on the firms abnormal returns (Balachandran et al., 2005).
Measurement of Variables Affecting Abnormal Returns

In this study, the effects of factors influencing cumulative abnormal returns have been
examined for two time periods: the first one being around one day of announcement
(t1 to t+1), and the second one being around 20 days of announcement (t20 to t+20).
In the case of equity issue announcement, the selection of the factors affecting abnormal
returns of a firm is primarily based on the previous studies in the context of both developed
and developing countries. A review of literature shows that there are several firm-specific,
issue-specific, industry-specific and country-specific factors that influence stock returns of
a firm apart from the announcement of an issue alone. The characteristics of firms determine
the degree of fluctuation in the abnormal returns (Tan et al., 2002; Balachandran et al., 2005;
and Elayan et al, 2007), and include parameters such as firm size, issue size, dividend yield,
research and development, intangible assets value, market capitalization, market-to-book
ratio, capital intensity, total liabilities, return on equity and leverage. The following variables
have been used in the study: Issue Size (ISSUE), Pre-Market Condition (PRECAR), Industry
Type (IT), Value of Collateral Assets (VCA), Return on Equity (ROE), Price-Earnings (PE)
ratio, Market Capitalization (MCAP), Operating Leverage (OPLEV), Debt-Equity (DE) ratio
and Volatility of Stock Returns (VSR).
Issue-Related Variables
The present study uses bonus issue ratio calculated as the number of shares allotted against
the current number of shares held by investors. In the case of rights issue, the number of
shares issued scaled by the number of shares outstanding has been taken as the issue-related
variables. The bonus issue size or the rights issue ratio has not been considered to avoid
duplication of data in the model.
Market-Related Factors
Investors start bidding up the prices prior to the announcement date, if they anticipate
revelation of information about the issue of bonus and rights shares. If the information is
already anticipated in the market, then the stock price reaction to the announcement will be
lower. Market condition can be captured through different variables such as cumulative
returns of the market index, volatility of index returns, etc. The variable cumulative returns
of the market index are arrived at by summing up the abnormal returns of the index before
the announcement date (normally 50 days prior to the announcement of an issue). It shows
the market trend around the event announcement. The second variable which captures
market condition is the volatility of index returns which is calculated as the standard deviation
of the market index before the event announcement. It shows the variability in the index
returns which might impact the abnormal returns of the firm around the seasoned capital
issue announcement. In the present study, we have used the cumulative abnormal returns of
the index prior to the bonus and rights issue announcement (PRECAR) to capture the
42
market condition, which is in line with other capital issue announcement studies carried out
by Tan et al. (2002) and Balachandran et al. (2005).
Industry Type
Initial analysis was carried out for separate industry groups, but since the sample size was
larger in relation to the number of independent variables, the analysis was done considering
all the firms together. Therefore, an industry dummy was included in the regression model to
examine the extent of influence of industry group on the abnormal returns around bonus and
rights issue announcement.
Measurement of Firm-Related Variables

Based on the literature review, firm-related variables indicating investment base, growth,
profitability and size of the firm have been identified in terms of VCA, ROE, PE and MCAP.
The risk of a company is analyzed by the investors considering a firms operating risk and
financial risk and the stock returns volatility, and hence these three variables are also included
in the model.
Value of Collateral Assets: The value of the collateral assets has been measured as the value
of the intangible assets scaled by total assets (Titman and Wessels, 1988), as investment plus
plant and machinery scaled by total assets (Elayan et al., 2007), and as net fixed assets scaled
by total assets (Johnson, 1997). In the present study, Johnson (1997) method is followed as it
seems to be more appropriate.
Return on Equity: Return on equity is used as a proxy for a firms profitability (Elayan et al.,
2007). It is calculated as the net income divided by the book value of the shareholders fund.
In line with the previous researchers, profitability has been captured by return on equity in
the current study. If a company has high return on equity, a greater proportion of future
economic benefit will be distributed to the shareholders. More return on equity will fetch
more future benefits to the investors and hence they react positively to the announcement of
an issue.
Price-Earnings Ratio: The researchers have used different proxies for growth of a firm, such
as market-to-book ratio, price-earnings ratio, Tobins Q ratio, total investment ratio and
research and development ratio. Market-to-book ratio is calculated as the market price of
the share divided by the book value of the share. Price-earnings ratio is calculated as the
market price to earnings per share. Price-earnings ratio has been used by Lukose and Sapar
(2004) in their study for examining firms operating performance around bonus issues. Priceearnings ratio is reported to have a positive relationship with a firms operating performance.
Hence, in the present study, following Ferri and Jones (1979), and Lukose and Sapar (2004),
we have used price-earnings ratio as a proxy for firms growth.
Firm Size: There are different proxy variables for size, namely, market capitalization, market
value of equity and total assets (Elayan et al., 2007), natural logarithm of sales (Titman and
Wessels, 1988; Kale et al., 1991; McConaughy and Mishra, 1996; and Kakani, 2001), and labor
turnover (Titman and Wessels, 1988). Balachandran et al. (2005) have used natural logarithm
of market value of a company one month prior to the bonus issue as a proxy for size in their
Factors Influencing Abnormal Returns Around Bonus
43
study on Australian market. Elayan et al. (2007) have used natural log of the market value of
equity used as a proxy for firms size. In the present study, we have chosen market capitalization
as a proxy for firms size which has been calculated as the log value of market capitalization.
Market capitalization is arrived at by multiplying the number of shares outstanding with the
closing stock price, thirty days prior to the announcement of an event.
Operating Leverage: In this study, risk is measured in terms of operating leverage to examine
if the effect on abnormal returns around bonus and rights issue announcement varies
depending on the measurement of risk. This ratio is calculated as a percentage change in
profit before depreciation, interests and taxes divided by the percentage change in sales
(Ferri and Jones, 1979).
Debt-Equity Ratio: Financial risk is calculated as debt-to-equity ratio, also termed as financial
leverage. It measures the degree to which an investor or business is utilizing borrowed money.
In literature, it is possible to note that different authors have used different methods for
measuring financial leverage: Long-term Debt/Total Assets (Johnson, 1997), Long-term Debt/
Equity (as used by practitioners); and Total Debt/Equity (Remmers et al., 1974). It represents
the debt-equity structure and indicates the financial risk of a firm (Wippern, 1966; Ferri and
Jones, 1979; Bowman, 1980; Titman and Wessels, 1988; McConaughy and Mishra, 1996;
Chatrath et al., 1997; and Johnson, 1997). The ratio used in this study is total debt divided by
equity as given in Prowess Database.
Volatility of Stock Returns: Volatility refers to the degree of (typically short-term) unpredictable
change over time of a certain variable. Volatility reflects the degree of risk faced by someone
with exposure to that variable. Past volatility pattern can affect the abnormal returns of the
company at the time of announcement as investors are aware of the past volatility patterns.
One can measure whether past volatility pattern affects the returns or not. Past volatility of the
stock returns has an inverse relationship with abnormal returns around announcement of
bonus and rights issues as high volatility in the market will have an adverse effect on a firm. In
this study, volatility of stock returns has been measured by standard deviation of daily stock
returns for 100 days before and after the bonus and rights issue announcement.
Methodology
The effect of issue size, market condition and industry effect on abnormal returns around
bonus and rights issue announcement has been examined using cross-sectional regression
analysis (Tsangarakis, 1996; Tan et al., 2002; and Brooks and Graham, 2005). Pearsons
correlation analysis has been done to identify whether multicollinearity exists among the
independent variables, and it is found that there is no multicollinearity among the
independent variables. The dependent variable has been taken as the cumulative abnormal
returns 20 days before the announcement to 20 days after the announcement, and cumulative
abnormal returns 1 day before the announcement to 1 day after the announcement. The
industry influence on the abnormal returns has been captured by using dummy variables for
different industry classes, namely, chemical, textile, IT and financial services. A step-wise
cross-sectional regression analysis has been performed to know the impact of firm-related
44
variables, followed by issue, market and industry-related variables. The analysis has been
carried out in the following stages to ascertain the explanatory power of each of these variables
on the dependent variable.
1. CAR (20, +20), CAR (1, +1) = Constant + 1 value of collateral assets +2 return
on equity + 3 price-earnings ratio + 4 market capitalization
on equity + 3 price-earnings ratio + 4 market capitalization +5 operating leverage
+ 6 debt-equity ratio + 7 volatility of stock returns
+ 6 debt-equity ratio + 7 volatility of stock returns + 8 bonus issue ratio
+ 6 debt-equity ratio + 7 volatility of stock returns + 8 bonus issue ratio + 9
market condition variable
+ 6 debt-equity ratio + 7 volatility of stock returns + 8 bonus issue ratio + 9
market condition variable + 10 industry dummy variable.
The validity of the regression model is examined using R2 and F-test.
Results
Issue Size, Market Condition and Industry Effects on Abnormal Returns Around
Bonus Issue Announcement
A correlation analysis among the independent variables was performed in order to see if the
independent variables are correlated. As per the correlation analysis, none of the variables
was found to be significantly highly correlated with other variables. The highest value found
for correlation is 0.420 between volatility of stock returns and market capitalization which is
significant at 0.05 level. Hence, one can conclude that there is no multicollinearity among
the variables chosen for the purpose of the study. The regression analysis has been undertaken
including all the sectors at once, and then for the manufacturing sector alone, followed by
service sector separately. The results are as follows.
Bonus Issue Announcement Reaction for the Dependent Variable CAR (20, +20)
A hierarchical regression was done combining both the industry sectors, viz., manufacturing
and service sector, to examine the overall bonus issue impact on the firms abnormal returns
for 20 days around the event announcement.
45
All the sectors combined: The effect of firm, risk, issue, market and industry-related variables
on the firms cumulative abnormal returns around 20 days of bonus issue announcement was
examined for all the sectors combined (Table 1). The results indicate the following observations:
1. Industry and the firm-related variables in the model show that F-statistics is not
significant but VCA is significant at 0.05 level. R2 is 0.078 and adjusted R2 is 0.037.
2. On inclusion of risk-related variables, MCAP, OPLEV and VSR become significant.
The F-statistics becomes significant at 0.001 level and the adjusted R2 drastically
improves over the previous model. MCAP is positive and significant whereas
OPLEV is negative and significant at 0.001 level.
3. On inclusion of bonus issue ratio in the model, the adjusted R2 gets reduced but the
F-statistics remained significant at 0.001 level. MCAP, OPLEV and VSR are
significant at 0.05, 0.001 and 0.001 levels, respectively.
4. Inclusion of market-related variables improved the adjusted R2 by 14% and the Fstatistics is significant at 0.01 level. MCAP, OPLEV, VSR and PRECAR are significant
and are positively influencing the abnormal returns, while OPLEV is having a
negative impact on the abnormal returns of the firms in the sample.
5. Only IT industry dummy is significant at 0.001 level and all other industry dummies
are insignificant, indicating that the type of industry also has an impact on the
nature of price reactions around bonus issue announcement. The models R2 is
59.3%, adjusted R2 becomes 0.546 which improved over the previous model and
the F-statistics is significant at 0.001 level. OPLEV, PRECAR and industry dummy
are the most significant variables affecting the abnormal returns around bonus
issue announcement. On inclusion of IT dummy variable, VSR and MCAP become
insignificant in the model. This implies that the variable industry dummy also
captures the size of the firm and the volatility of the firms in that particular industry
class and hence they become insignificant on inclusion of industry dummy in the
model.
Manufacturing sector: Based on the results, the following observations have been made:
1. Only firm-related variables have no significant impact on the abnormal returns
around 20 days of bonus issue announcement.
2. Inclusion of risk-related variables above the firm-related variables improves the
models explanatory power by 0.147. Volatility of stock returns has the most
significant coefficient affecting the abnormal returns.
3. Issue-related variable, i.e., bonus issue ratio does not have any significant impact
on the abnormal returns around bonus issue announcement. However, volatility
46

47
0.054
MCAP
1.922
F-Stat. (Prob.)
8.550 (***)
0.357
7.473 (***)
0.353
0.407
0.051
0.368(***)
0.085
0.48(***)
0.202(*)
0.106
0.02
0.045
Beta Coeff.
Issue
11.520 (***)
0.499
0.547
0.377(***)
0.035
0.385(***)
0.102
0.47(***)
0.189(**)
0.082
0.045
0.034
Beta Coeff.
Market
Note: *, **, *** represent significance at 0.01, 0.05 and 0.001 levels, respectively.
0.037
Adj. R2
FINDUM
ITDUM
TEXTDUM
CHEMDUM
PRECAR
0.405
0.371(***)
VSR
BR
0.078
0.48(***)
0.211(**)
0.113
0.02
DE
0.078
0.024
PE
OPLEV
0.143
0.042
Beta Coeff.
Beta Coeff.
0.246(**)
Risk
Firm
ROE
VCA
Variables
10.594 (***)
0.502
0.555
0.108
0.371(***)
0.038
0.346(***)
0.115
0.43(***)
0.158
0.067
0.058
0.032
Beta Coeff.
CHEMDUM
10.268 (***)
0.494
0.547
0.027
0.38(***)
0.036
0.379(***)
0.099
0.47(***)
0.189(**)
0.084
0.04
0.041
Beta Coeff.
TEXTDUM
12.410 (***)
0.546
0.593
0.35(***)
0.37(***)
0.069
0.116
0.093
0.48(***)
0.094
0.045
0.025
0.085
Beta Coeff.
ITDUM
Table 1: Bonus Issue Hierarchical Cross-Sectional Regression for Manufacturing

and Service Sectors Combined, Dependent Variable CAR (20, +20)
10.455 (***)
0.499
0.552
0.129
0.364(***)
0.041
0.36(***)
0.088
0.58(***)
0.202(**)
0.078
0.044
0.019
Beta Coeff.
FINDUM
of stock returns and market capitalization are significantly affecting the abnormal
returns.
4. On inclusion of market-related variable in the model, the models explanatory
power increases by approximately 13.1%. Volatility of stock returns (0.488), and
PRECAR (0.376) are significantly and positively affecting the abnormal returns
around bonus issue announcement.
5. Industry dummy variable differentiating between chemical and textile industry
does not have any significant impact on the abnormal returns of the firm but in
the model, PRECAR and VSR are significantly and positively affecting the abnormal
returns.
Service sector: The effect of firm, risk, issue, market and industry-related variables on the
firms cumulative abnormal returns around 20 days of bonus issue announcement was examined
for service sector separately so as to examine the impact of bonus issue announcement in
service sector alone. Two industries, namely, IT and financial services sectors, have been
chosen for the purpose of the study. The results show the following observations:
1. Only firm-related variables are not having any significant impact on the abnormal
returns when included in the regression model separately.
2. On inclusion of risk-related variables, namely, VSR, DE and OPLEV, the models R2
improves and the variables OPLEV and DE are having a significant beta coefficient.
The R2 becomes 0.224 as against 0.011, but the F-statistics is not significant.
3. On inclusion of issue-related variable, bonus issue ratio, the adjusted R2 drops.
However, OPLEV and DE are significant at 0.10 level.
4. On inclusion of market-related variables, the model turns significant as the Fstatistics is significant at 0.01 level. R2 is 0.587, which is an improvement over the
previous model and the adjusted R2 is 0.426, which is again an improvement over
the previous model. OPLEV, DE and PRECAR are significant at 0.05, 0.05 and 0.01
levels, respectively.
5. As the industry dummy is included in the model, the R2 becomes 0.658 and the
adjusted R2 also improves drastically to 0.502. F-statistics is significant at 0.01
level. The dummy variable is significant which tells that industry is an important
factor in the price reaction. The type of the industry accounts for the changes in
stock price around bonus issue announcement. PRECAR (0.462) is significant at
0.01 level and OPLEV (0.710) is significant at 0.01 level. Overall, the model
explains 65.8% variation in the dependent variable.
The results show that operating leverage and pre-market condition and volatility of
stock returns are the most significant variables affecting the cumulative abnormal returns
around bonus issue announcement. These variables remain significant even after including
48
the dummy variables for different industry classes. Overall, maximum influence is of OPLEV
(0.475), followed by PRECAR (0.370), IT dummy (0.350), DE (0.093), VCA (0.085), VSR
(0.116), BR (0.069), MCAP (0.094), PE (0.045) and ROE (0.025).
In summary, the result that different variables affect abnormal returns around
announcement of bonus issue supports the previous studies results (Tan et al., 2002; and
Lukose and Sapar, 2004). The results show that at the time of bonus issue announcement,
not only the announcement has an impact on the abnormal returns of the firm but, other
variables concerning the companys performance like OPLEV (risk variable), PRECAR and
the type of industry (Industry Dummy) also affect a firms abnormal returns. This implies
investors rationality towards their investment decisions. The investors not only undertake
the technical analysis of the stock, but also see the fundamentals of the firm in which they
intend to invest. Information asymmetry is also observed at the time of announcement as
the abnormal returns change significantly. However, bonus issue ratio is not having any
significant impact on the abnormal returns which implies that investors are not interested
in knowing the ratio in which bonus issue is declared but they are more interested in knowing
the fundamentals of the company.
Bonus Issue Announcement Reaction for CAR (1, +1)

Based on the results presented in Table 2, the following observations are made:
1. MCAP and OPLEV are the most significant variables explaining the variation in
the dependent variable (CAR 1, +1), followed by volatility of stock returns and
pre-market condition before the bonus issue announcement. Market capitalization
is having a positive coefficient signifying that the abnormal returns will be higher
for the firms having higher market capitalization. Signaling theory holds true in
this case as the size of the company significantly impacts the abnormal returns of
the firms at the time of bonus issue announcement.
2. Operating leverage is also significant which implies that the investors assess the
risk of the particular stock before investing in it. Risk plays a major role in the
nature of stock price reaction around bonus issue announcement. Volatility of
stock returns is another variable which is impacting the abnormal returns which
tells that if the stock is volatile, the stock price reaction will be more volatile and
that higher volatility induces higher stock price reaction around bonus issue
announcement.
3. Industry dummy for the financial services and IT industry is significant which
implies that the type of industry has a significant impact on the abnormal returns
around bonus issue announcement and in particular financial services and IT
industries are significantly impacting the nature of reaction around bonus issue
announcement in a short event window (CAR 1, +1). PRECAR is significant
which implies that the market condition before the issue announcement affects
the stock price reaction around announcement. It has a positive coefficient which
49
50
0.076
0.168
PE
MCAP
0.251(**)
VSR
1.675
F-Stat. (Prob.)
0.275
0.336
0.028
0.249(**)
0.12
0.482(***)
0.271(**)
0.05
0.048
0.088
Beta Coeff.
Issue
5.547 (***)
0.301
0.367
0.178(**)
0.021
0.257(**)
0.128
0.48(***)
0.266(**)
0.039
0.06
0.082
Beta Coeff.
Market
6.348 (***) 5.510 (***)
..283
0.028
Adj. R
0.336
0.069
R2
FINDUM
ITDUM
TEXTDUM
CHEMDUM
PRECAR
BR
0.116
0.485(***)
0.277(***)
0.054
0.048
DE
OPLEV
0.179
ROE
0.086
Beta Coeff.
Beta Coeff.
0.184
Risk
Firm
VCA
Variables
4.935(***)
0.293
0.367
0.004
0.178(**)
0.02
0.259(**)
0.127
0.482(***)
0.267(**)
0.04
0.06
0.083
Beta Coeff.
CHEMDUM
4.970 (***)
0.295
0.369
0.049
0.183(**)
0.022
0.246(**)
0.123
0.477(***)
0.265(**)
0.043
0.051
0.095
Beta Coeff.
TEXTDUM
5.664 (***)
0.329
0.4
0.292(**)
0.172(**)
0.049
0.033
0.12
0.481(***)
0.186
0.008
0.044
0.125
Beta Coeff.
ITDUM
Table 2: Bonus Issue Hierarchical Cross-Sectional Regression for Manufacturing

and Service Sectors Combined, Dependent Variable CAR (1, +1)
5.915 (***)
0.341
0.41
0.379(**)
0.14(*)
0.037
0.184(*)
0.088
0.779(***)
0.303(***)
0.027
0.056
0.037
Beta Coeff.
FINDUM
means that if the market trend is increasing before the announcement, the abnormal
returns will also be positive. In other words, we can say that if the announcement
is made at the time when investors sentiments are positive, it will fetch a positive
reaction as against the time when the market sentiment is negative.
Thus, the analysis shows that it is not only the event announcement (bonus issue
announcement) that affects the abnormal returns, but the variables like firm-related variables,
risk-related variables, industry type and market-related variables also affect the abnormal
returns. In the case of cumulative abnormal returns around one day and 20 days of bonus issue
announcement, the type of industry is having a significant impact on the abnormal returns
of the firms, which explains that the nature of industry plays a major role in deciding the
nature of stock price reaction around bonus issue announcement. Moreover, firms operating
leverage, volatility of the stock returns, pre-market condition, and market capitalization also
explain the nature of reaction and they significantly influence the abnormal returns around
the bonus issue announcement date.
Issue Size, Market Condition and Industry Effects on Abnormal Returns Around
Rights Issue Announcement
An analysis of factors influencing abnormal returns has been carried out for the rights issue
sample as a whole and not specific industry-wise as the number of firms with rights issue
announcement were very few in individual sectors. In the case of chemical sector, there are
only 16 firms. In the textile sector, only 10 firms have come up with rights issue announcement.
Likewise in the case of IT and financial services sectors, there are only 12 and 18 firms,
respectively, which have come up with rights issue announcement. Hence, it was pertinent
to carry out a cross-sectional regression analysis to examine the impact of factors influencing
abnormal returns around the rights issue announcement.
Factors Influencing Cumulative Abnormal Returns (CAR 20 to +20) Around Rights

Issue Announcement
A hierarchical regression was performed combining both the industry sectors, viz.,
manufacturing and service, to examine the overall impact of rights issue on the firms abnormal
returns for 20 days around the event announcement (Table 3). On inclusion of firm-related
variables in the regression model, the model was not significant, which implies that there are
other variables to be included in the model which impact the abnormal returns. Moreover,
no firm-related variable was significant according to t-test.
As the next step, risk-related variables were included in the model, and the results revealed
that no variable was significant again according to the t-test values. The model was also
insignificant as the F-statistics was not significant.
In the next phase, issue-related variables were included in the model and the model was
significant at 1% level. R2 was 0.556 and the adjusted R2 was 0.309. The variable MCAP has a
negative relationship with the abnormal returns, and was significant at 0.01 level. Likewise,
51
rights issue proceeds had a positive relationship with the abnormal returns and were significant
at 0.01 level. All other variables were insignificant.
As the next step, market-related variables were included in the regression model and the
results showed that MCAP and rights issue proceeds were the two variables significant at
0.01 level. R2 was 0.583 and the adjusted R2 was 0.339. Overall, the model F-statistics was
significant at 0.10 level.
As the last step, industry dummy was included in the model and the variables MCAP and
issue proceeds were found to be significant at 0.01 level. MCAP has a negative relationship
with cumulative abnormal returns around 20 days of rights issue announcement, whereas
issue proceeds has a negative relationship with the cumulative abnormal returns around 20
days of rights issue announcement. Industry dummy has no significant impact on the abnormal
returns in the case of rights issue announcement.
Factors Influencing Cumulative Abnormal Returns (CAR 1 to + 1) Around Rights

Issue Announcement
A hierarchical cross-section regression analysis was performed taking the dependent variable
as cumulative abnormal returns for the days t 1 to t + 1 to examine how the firm, risk,
market, issue and industry-related variables influence the abnormal returns around the rights
issue announcement (Table 4).
In the first step of analysis, only the firm-related variables were included in the study and
the effect was observed on the cumulative abnormal returns of the firms in the sample. The
variables which have a negative impact on the abnormal returns are the value of collateral
assets, price-earnings ratio, market capitalization, operating leverage and volatility of stock
returns. The model calls for inclusion of more variables, hence, in the next step, we included
issue-related variables in the model.
In order to examine the impact of market-related variables on cumulative abnormal
returns around rights issue announcement, we included PRECAR (market condition variable
which captures the market condition before the rights issue announcement) and see whether
the pre-issue market condition affects the abnormal returns around announcement of rights
issue. The results obtained show that the PRECAR variable has a negative relationship with
the abnormal returns around the rights issue announcement. No variable in the model is
found to be significant. Overall, the model is not significant and the R2 is 0.328 as against the
previous model, which was 0.313.
In order to examine whether there is a significant industry impact on the abnormal
returns, a dummy variable for the type of industry has been included in the regression model.
The dummy variable has no significant impact on the abnormal returns around one day of
rights issue announcement. This implies that the nature of reaction around rights issue
announcement does not depend on the type of industry for which the rights issue is being
announced. Overall, the model R2 is 0.362, and the adjusted R2 is 0.131. The models
F-statistics is not significant.
52

53
2.011(*)
1.074
1.998(*)
1.747
0.339
1.085
0.339
F-Stat. (Prob.)
0.309
0.098
Adj. R2
0.169
0.583
0.583
0.313
0.198
0.521(***)
0.056
0.005
0.124
0.542(***)
0.005
0.041
0.064
Beta Coeff.
Industry Dummy
R2
0.198
0.52(***)
0.056
0.006
0.125
0.542(***)
0.005
0.042
0.067
Beta Coeff.
Market
0.004
0.556
0.548(***)
0.019
0.056
0.203
0.535(***)
0.041
0.071
0.026
Beta Coeff.
Issue
INDDUMMY
PRECAR
0.411
0.098
VSR
ISSUE
0.029
0.224
DE
0.175
MCAP
0.085
0.338
0.068
PE
0.083
OPLEV
0.042
ROE
0.005
Beta Coeff.
Beta Coeff.
0.231
Risk
Firm
VCA
Variables
Table 3: Hierarchical Cross-Sectional Regression for CAR 20, +20, Rights Issue All Sectors Combined
54
0.188
0.233
PE
MCAP
0.09
0.995
Adj. R2
F-Stat. (Prob.)
0.551
0.094
Issue
0.49
0.098
0.313
0.089
0.032
0.048
0.067
0.287
0.211
0.267
0.18
Beta Coeff.
0.301
R2
INDDUM
PRECAR
0.307
0.051
VSR
ISSUE
0.052
0.045
0.236
0.204
0.266
DE
OPLEV
0.22
ROE
0.185
Beta Coeff.
Beta Coeff.
0.169
Risk
Firm
VCA
Variables
0.468
0.107
0.328
0.108
0.105
0.053
0.02
0.024
0.283
0.186
0.252
0.13
Beta Coeff.
Market
0.514
0.131
0.362
0.268
0.113
0.148
0.053
0.063
0.112
0.284
0.196
0.297
0.042
Beta Coeff.
Industry Dummy
Table 4: Hierarchical Cross-Sectional Regression for CAR 1, +1, Rights Issue All Sectors Combined
The results show that no variable is significantly affecting the cumulative abnormal
returns around one day of the rights issue announcement. There is also no effect of the
different types of industries on the abnormal returns of the firm. Overall, the price-earnings
ratio, market capitalization, operating leverage, volatility of stock returns and the pre-market
condition have a negative relationship with the CAR around one day of rights issue
announcement but no variable is significant. This result also throws light on the fact that
the rights issue announcement is having a significant impact on the abnormal returns around
one day of announcement, and firm, risk, market, issue or industry-related variables are not
affecting the abnormal returns. The event itself has an impact on the abnormal returns of the
firm.
In summary, the result of factors influencing abnormal returns around rights issue
announcement does not support the findings of previous studies (Tan et al., 2002; and Lukose
and Sapar, 2004). The results show that at the time of rights issue announcement, only the
announcement itself has the maximum impact on the abnormal returns of the firms, as no
other variable is significantly impacting the abnormal returns. As indicated in the results,
the type of industry also does not have an impact.
Discussion
It may be inferred that market condition and industry have significant influence on abnormal
returns and IT industry has inverse relationship with abnormal returns for bonus issue
announcement. The bonus ratio does not have any significant effect on abnormal returns.
However, for rights issue announcement, issue size and market condition is significantly
influencing abnormal returns. The firm size, operating leverage, debt-equity ratio, volatility
of stock returns are the other firm-related factors influencing stock returns around bonus
issue announcement. But for rights issue, only firm size is the significant firm-related factor
influencing abnormal returns.
The sector-wise analysis indicates that pre-market condition is having a significant impact
on abnormal returns across industries and IT sector has a negative impact on abnormal
returns for bonus issue announcement for manufacturing sector. For cumulative abnormal
returns around one day, bonus issue significantly influences the abnormal returns in
manufacturing sector but it is not true for service sector. The results of the analysis are
summarized in Tables 5 and 6.
Hence, the study shows empirical evidence of market condition positively influencing
abnormal returns around bonus and rights issue announcement similar to Choe et al. (1993),
Tsangarakis (1996) and Tan et al. (2001). Issue size is another significant factor influencing
abnormal returns around rights issue announcement which is similar to findings in Germany
and Hong Kong and in contrast to the US market where issue size has negative influence.
The industry effect has significant influence on abnormal returns around bonus issue
announcement similar to Elayan and Pukthuanthong (2004) who reported significant
influence for contract announcements.
55
Table 5: Summary of Impact of Bonus and Rights Issue Announcement

for CAR +20 and 20, All Sectors Combined
Variables
Variables
Name
Bonus Issue
Rights Issue
Announcement
Announcement
CAR 20, CAR +20
CAR 20, CAR +20
VCA
Negative, not significant
ROE
PE
MCAP
Positive, significant
Negative, significant
OPLEV
Positive, not significant
DE
VSR
Issue size
BR
Market condition
PRECAR
Positive not significant
Industry
INDDUM
Firm-related variables
Risk
Table 6: Summary of Impact of Bonus and Rights Issue Announcement

for CAR 1 and CAR +1, All Sectors Combined
Variables
Firm-related variables
Variables
Name
Bonus Issue
Announcement
CAR 1, CAR +1
Rights Issue
Announcement
CAR 1, CAR +1
VCA
Negative, insignificant
Positive, insignificant
ROE
PE
MCAP
OPLEV
DE
VSR
Issue size
BR
Market condition
PRECAR
Industry
INDDUM
Risk
56
We find evidence of firms with low growth preferring to go for rights offerings or bonus
issues similar to Heron and Lie (2004). The firm size has a positive influence on the stock
prices for bonus issue announcement similar to Kim and Limpaphayom (2000), Elayan et al.
(2007) Lukose and Rao (2004) and Wu et al. (2005). The abnormal returns are negatively
related to firm size for rights issue announcement similar to Kang and Stulz (1996), Mohanty
(2001) and Brooks and Graham (2005). The volatility of stock returns is positively related to
abnormal returns for both bonus and rights issue announcement in contrast to Lamoureux
and Poon (1987), Dravid (1987), Dierkens (1991), Tan et al. (2002), and Huddart and Ke
(2007) who find that there is a negative relationship between the variance of stock returns
and the stocks abnormal returns. Thus, we find that different firm characteristics have a
significant effect on the firms abnormal return and it is different for bonus and rights issue
announcements.
Conclusion
It can be inferred that for bonus issue, investors consider risk of the firm, size of the firm, premarket condition, and the type of industry, whereas in the case of rights issue the investors
consider size of the firm and the issue size while reacting to announcements. The findings
indicates that the market condition hypothesis is accepted and firms should attempt to
announce bonus issue when the market is in an upward trend, as it is a significant factor
influencing the investors reaction. If an announcement is made in the bullish market, the
reaction is likely to be positive and vice versa. The firms should consider the issue size while
planning to announce a rights issue in the market, as the size of the issue signals about the
quality of the issue and investors get the signal from such announcements. Thus, the study
provides evidence of stock abnormal returns being significantly influenced by the event and
firm-related, market condition and industry-related factors.
References
1.
Abhyankar A and Dunning A (1999), Wealth Effects of Convertible Bond and

Convertible Preference Share Issues: An Empirical Analysis of the UK Market, Journal
of Banking and Finance, Vol. 23, No. 7, pp. 1043-1065.
2.
Altman E I (1968), Financial Ratios, Discriminant Analysis and the Prediction of

Corporate Bankruptcy, The Journal of Finance, Vol. 23, No. 4, pp. 589-609.
3.
Asquith P and Mullins W (1986), Signalling with Dividends, Stock Repurchases, and
Equity Issues, Financial Management, Vol. 15, No. 3, pp. 27-44.
4.
Balachandran B, Faff L and Jong L (2005), Announcements of Bonus Share Options:

Signalling of the Quality of Firms, Global Finance Journal, Vol. 16, No. 2, pp. 180-190.
5.
Barclay M, Litzenberger E and Warner B (1990), Private Information, Trading Volume

and Stock Return Variances, The Review of Financial Studies, Vol. 3, No. 2, pp. 233-253.
6.
Bigelli M (2002), The Quasi-Split Effect, Active Insiders and the Italian Market
Reaction to Equity Rights Issues, European Financial Management, Vol. 4, No. 2,
pp. 185-206.

57
7.
Bowman R G (1980), The Importance of a Market-Value Measurement of Debt in

Assessing Leverage, Journal of Accounting Research, Vol. 18, No. 1, pp. 242-254.
8.
Brooks J and Graham E (2005), Equity Private Placements, Liquid Assets, and Firm
Value, Journal of Economics and Finance, Vol. 29, No. 3, pp. 321-336.
9.
Chatrath A, Kamath R, Ramachander S and Chaudary M K (1997), Cost of Capital,

Capital Structure and Dividend Policy: Theory and Evidence, Finance India, Vol. 11,
pp. 1-16.
10.
Choe H, Masulis R W and Nanda V (1993), Common Stock Offerings Across the
Business Cycle, Journal of Empirical Finance, Vol. 1, No. 1, pp. 3-31.
11.
Dierkens N (1991), Information Asymmetry and Equity Issues, Journal of Financial

and Quantitative Analysis, Vol. 26, No. 2, pp. 181-198.
12.
Dravid A R (1987), A Note on the Behavior of Stock Returns Around Ex-Dates of

Stock Distributions, The Journal of Finance, Vol. 42, No. 1, pp. 163-168.
13.
Elayan F A, Pukhthuanthong K and Rose L C (2007), Equity and Debt Market

Responses to Sovereign Credit Ratings Announcements, Global Finance Journal,
Vol. 18, No. 1, pp. 23-54.
14.
Ferri M G and Jones W H (1979), Determinants of Financial Structure: A New

Methodological Approach, Journal of Finance, Vol. 34, No. 3, pp. 631-644.
15.
Flath D and Knobber C R (1980), Taxes, Failure Costs, and Optimal Industry Capital
Structure: An Empirical Test, The Journal of Finance, Vol. 35, No. 1, pp. 99-117.
16.
Foss G W (1995), Quantifying Risk in the Corporate Bond Market, Financial Analysts
Journal, Vol. 51, March-April, pp. 29-34.
17.
Heron R A and Lie E (2004), A Comparison of the Motivations for and the Information
Content of Different Types of Equity Offerings, Journal of Business, Vol. 77, No. 3,
pp. 605-632.
18.
Hess A C and Bhagat S (1986), Size Effects of Seasoned Stock Issues: Empirical
Evidence, The Journal of Business, Vol. 59, No. 4, pp. 567-584.
19.
Huddart S J and Ke (2007), Information Asymmetry and Cross-Sectional

Determinants of Insider Trading, Contemporary Accounting Research, Vol. 24, No. 1,
pp. 33-47.
20.
Johnson S A (1997), An Empirical Analysis of the Determinants of Corporate Debt

Ownership Structure, Journal of Financial and Quantitative Analysis, Vol. 32, No. 1,
pp. 47-69.
21.
Kakani R K, Saha B and Reddy V N (2001), Determinants of Financial Performance of

Indian Corporate Sector in the Post-Liberalization Era: An Exploratory Study,
58
National Stock Exchange of India Limited, NSE Research Initiative Paper No. 5,
available at http://ssrn.com/abstract=904983.
22.
Kalay A and Shimrat A (1987), Firm Value and Seasoned Equity Issues: Price Pressure,
Wealth Redistribution, or Negative Information, Journal of Financial Economics,
Vol. 19, No. 1, pp. 109-126.
23.
Kale J R, Noe T H and Ramirez G G (1991), The Effect of Business Risk on

Corporate Capital Structure: Theory and Evidence, Journal of Finance, Vol. 46, No. 5,
pp. 1693-1715.
24.
Kang J K and Stulz R M (1996), How Different is Japanese Corporate Finance? An

Investigation of the Information Content of New Equity Issues, Review of Financial
Studies, Vol. 9, pp. 109-139.
25.
Kato H K and Tsay W (2002), Are Stock Dividends (MUSHOs) Melons or Lemons in
Japan?, Pacific-Basin Finance Journal, Vol. 10, No. 5, pp. 531-548.
26.
Kim K A and Limpaphayom P (2000), Characteristics of Stocks That Frequently Hit

Price Limits: Empirical Evidence from Taiwan and Thailand, Journal of Financial Markets,
Vol. 3, No. 3, pp. 315-332.
27.
Lamoureux C G and Poon P (1987), The Market Reaction to Stock Splits, Journal of
Finance, Vol. 42, No. 5, pp. 23-43.
28.
Lukose J and Sapar N R (2004), Agency Cost, Investment Opportunity and the Rights
Equity Issue Decision: Evidence from an Emerging Market, available at http://ssrn.com/
abstract=669462
29.
Marsden A (2000), Shareholder Wealth Effects of Rights Issues: Evidence From the
New Zealand Capital Market, Pacific-Basin Finance Journal, Vol. 8, Nos. 3 and 4,
pp. 419-442.
30.
Martin J D and Scott D F Jr. (1974), A Discriminant Analysis of the Corporate DebtEquity Decision, Financial Management, Vol. 3, No. 4, pp. 71-79.
31.
McConaughly D L and Mishra C S (1996), Debt, Performance-Based Incentives, and

Firm Performance, Financial Management, Vol. 25, No. 2, pp. 37-51.
32.
Mikkelson W H and Partch M M (1986), Valuation Effect of Security Offerings and

the Issuance Process, Journal of Financial Economics, Vol. 15, pp. 31-60.
33.
Mohanty B (1997), Slump in Securities Market: Problems and Strategies for Its
Sustainable Growth, Economic and Political Weekly, October, pp. 2733-2746.
34.
Remmers L, Stonehill A, Wright R and Beekhuisen T (1974), Industry and Size as

Debt Ratio Determinants in Manufacturing Internationally, Financial Management,
Vol. 3, pp. 24-32.

59
35.
Tan R S K, Chng P L and Tong Y H (2002), Private Placements and Rights Issues in
Singapore, Pacific-Basin Finance Journal, Vol. 10, No. 1, pp. 29-54.
36.
Titman S and Wessels R (1988), The Determinants of Capital Structure Choice,

Journal of Finance, Vol. 43, No. 1, pp. 1-19.
37.
Tsangarakis N V (1996), Shareholder Wealth Effects of Equity Issues in Emerging

Markets: Evidence from Rights Offerings in Greece, Financial Management, Vol. 25,
No. 3, pp. 21-32.
38.
White R and Lusztig P (1980), The Price Effects of Rights Offerings, Journal of Financial
and Quantitative Analysis, Vol. 15, No. 1, pp. 25-40.
39.
Wippern R F (1966), Financial Structure and the Value of the Firm, The Journal of
Finance, Vol. 21, No. 4, pp. 615-633.
40.
Wu X, Wang Z and Yao J (2005), Understanding the Positive Announcement Effects

of Private Equity Placements: New Insights from Hong Kong Data, Review of Finance,
Vol. 9, No. 3, pp. 385-414.
Reference # 01J-2013-10-03-01
60
Did the Great East Japan Earthquake

Have an Impact on the Market
for Long-Term Interest Rates in Japan?
Takayasu Ito*
This paper focuses on the structural change in the market for long-term interest rates in Japan before and after the
Great East Japan Earthquake (Earthquake) by analyzing co-movement and transmission. Before the Earthquake,
Japanese interest rate swaps and Tokyo Electric Power Company bonds moved together. On the other hand, Japanese
government bonds and Japanese interest rate swaps moved together after it. There was no transmission among the
three interest rates before the Earthquake. But after the Earthquake, there was transmission between Japanese
government bonds and Japanese interest rate swaps. Therefore, it can be concluded that the market for long-term
interest rates in Japan changed structurally after the Earthquake.
Introduction
The Great East Japan Earthquake (hereinafter referred to as the Earthquake) of March 11,
2011 caused a lot of damage. In addition to the destruction caused by the tremor and subsequent
tsunami (tidal wave), the devastation of the nuclear power plants in Fukushima dealt a
serious blow to the power supply capacity of the Tokyo Electric Power Company. The concern
that the company would be liable for the costs of disposing the shuttered nuclear power plant
and that the compensation for the damages was widespread, prevailed in the financial market.
Hence, the prices of the Tokyo Electric Power Company bonds declined sharply after the
Earthquake, amid growing credit risk.
We usually refer to government bonds, interest rate swaps, and corporate bonds as
benchmarks of long-term interest rates in Japan. 1 Japanese government bond yields are
supposed to be the lowest of the three interest rates because they bear the least credit risk.
Swap rates are representative of credit risk in the banking sector. Corporate bonds are
representative of the private sector other than banking. In other words, these three kinds of
interest rates represent the benchmarks to indicate the cost of borrowing in each sector. The
Earthquake might have had an impact on long-term interest rates in Japan because the yields
of the Tokyo electric power company bonds rose sharply after the accident.
This is the revised version of the paper presented at the International Conference on Education, Applied
Sciences and Management 2012 held at Dubai, UAE.
* Professor, Faculty of Economics, Niigata University, 8050, Ikarashi 2-no-cho, Nishi-ku, Niigata City 950-2181,
Japan. E-mail: tito@econ.niigata-u.ac.jp
1
Most of the corporate bonds in Japan are not traded actively in 10-year zone. But the Tokyo Electric Power
Company Bond is relatively well traded. The yields of end day data are available.
2013
. All
Rights
Did
the IUP
Great
East
JapanReserved.
Earthquake Have an Impact on the Market
61
The purpose of this paper is to investigate the impact of the Earthquake on the market for
long-term interest rates in Japan. It focuses mainly on the structural changes in the market
before and after the Earthquake by analyzing co-movement and transmission. So far no study
has analyzed the impact of the Earthquake on the market for long-term interest rates in
Japan. Thus, this paper is the first and original work on the subject.
A limited number of related papers analyze the market structure of long-term interest rates.
Morris et al. (1998) analyze the linkage between US corporate bonds and government securities.
Ito (2009) looks at the relationship between Japanese government bonds and interest rate
swaps using the same method. The study concludes that the market for Japanese long-term
interest rates changed structurally after the Bank of Japan introduced the zero interest rate
policy. Ito (2010) focuses on the determinants of Japanese interest rate swap spreads under
different monetary policy regimes.
In this paper, the method of Morris et al. (1998) is applied to investigate the linkage of longterm interest rates in Japan before and after the Earthquake.
Data
The study covers a sample period of three years from September 11, 2009 to September 11,
2012. The sample period is divided into two periods around the time of the Earthquake. The
first period (Sample A) runs from September 11, 2009 to March 11, 2011 and the second
(Sample B) from March 14, 2011 to September 11, 2012. The Earthquake occurred at around
14:46, just before the markets closed. Therefore its impact was not felt on the day of occurrence.
Methodology
Unit Root Test
Since empirical analysis from the mid-1980s through the mid-1990s shows that the data
such as interest rates, foreign exchange, and stocks are non-stationary, it is necessary to
check if the data used in this paper contains unit roots. The Augmented Dickey-Fuller
(ADF) and Phillips-Perron (PP) tests are used. Both tests define the null hypothesis as unit
roots exist and the alternative hypothesis as unit roots do not exist.2 Fuller (1976) provides
the tables for the ADF and PP tests.
Cointegration Test
A non-stationary time series model is necessary to cope with the problems mentioned above.
There are two main types of cointegration tests: (1) Engle and Granger (1987); and
(2) Johansen (1988). The most difficult part of cointegration analysis starting from the
Vector Auto Regression (VAR) model is deciding on the number of cointegration
relationships. When three variables are analyzed, the number of such relationships may be
2
62
See, Dickey and Fuller (1979) and (1981); and Phillips and Perron (1988).
either one or two. Engle and Granger method cannot cope with this problem, but Johansens
approach provides a means to decide the number of cointegration relationships.
Johansen suggests the analysis with the k order VAR model. Here, the VAR model is
presented with k order against vector X t with p variables. The critical values at 5% and 10%
levels are taken from Osterwald-Lenum (1992).
X t 1 X t 1 ... k X t k u t
...(1)
All the p elements of Xt are considered to be I(1) variables, ut is an error term with zero mean,
and is a constant term.
After the non-stationarity of the data is confirmed by unit root tests, Johansens
cointegration tests are applied to investigate the linkage of the three interest rates. Maximal
eigenvalue and trace tests are conducted to test cointegration. The analysis is conducted by
investigating the co-movement of three 10-year interest ratesJapanese government bonds,
Japanese interest rate swaps, and Tokyo Electric Power Company bondsand by investigating
the co-movement in a pair out of these three interest rates.
Granger Causality Test

The Granger causality test is applied to investigate the causalities among three interest rates.
The original data is usually transformed into the change ratio to avoid the problem of spurious
regression; however, using these data could cause an error. Toda and Yamamoto (1995)
developed the Granger causality test in which non-stationary data is used directly. According
to their method, the null hypothesis is tested by adding the trend term t and
p + 1 (original lag plus one) for the estimation of the following three equations.
These three equations are used to test the three interest rates. For example, Equation (2)
checks if the Japanese interest rate swaps (IS), Tokyo Electric Power Company bonds (TE)
and Japanese government bonds (JG) Granger-cause Japanese government bonds.
p1
p1
p1
i 1
i 1
i 1
p1
p1
p1
i 1
i 1
i 1
JGt 0 t i ISt i i TEt i i JGt 1 ut

ISt 0 t i JGt i i TEt i i ISt 1 ut
p1
p1
p1
i 1
i 1
i 1
TEt 0 t i ISt i i JGt i i TEt 1 ut
...(2)
...(3)
...(4)

The daily closing yields of Japanese government bonds, Japanese interest rate swaps, and
Tokyo Electric Power Company bonds are used as the data. The data for the first two are
provided by Mitsubishi UFJ Morgan Stanley Securities and for the last by the Japan Securities
Dealers Association. The movements of the data are shown in Figure 1.
Did the Great East Japan Earthquake Have an Impact on the Market
63
Figure 1: Movement of Three Series

Sample A
1.8
1.6
1.4
Percent
1.2
1.0
JY
0.8
0.6
0.4
0.2
09/16/2010
10/18/2010
11/15/2010
12/13/2010
01/13/2011
02/09/2011
03/09/2011
08/20/2010
03/05/2010
04/02/2010
04/30/2010
06/01/2010
06/28/2010
07/26/2010
11/11/2009
12/09/2009
01/08/2010
02/05/2010
09/11/2009
10/14/2009
Sample B
9
8
Percent
7
6
5
JY
Y
E
4
3
2
08/14/2012
04/14/2012
05/14/2012
06/14/2012
07/14/2012
02/14/2012
03/14/2012
01/14/2012
11/14/2011
12/14/2011
10/14/2011
08/14/2011
09/14/2011
07/14/2011
03/14/2011
04/14/2011
05/14/2011
06/14/2011
Note: In all the tables and figures, JY = 10-year Japanese government bonds; Y = 10-year Japanese interest rate
swaps; and E = 10-year Tokyo Electric Power Company bonds. Sample A refers to the period from
September 11, 2009 to March 11, 2011; and Sample B refers to the period from March 14, 2011 to September
11, 2012.
64
Unit Root Test

The ADF and PP tests are conducted for both, with time trend and without time trend. The
AIC standard is used for determining the lag length of the ADF test. The critical point of 5%
for the t-type of T = is 2.86 (without trend) and 3.41 (with trend) as shown in Fuller
(1976). The results are shown in Tables 1 and 2. There is no denying that all the variables are
non-stationary.
Table 1: Results of ADF Test (Original Series)
Variable
Without Trend
With Trend
Sample A
JY
1.682
1.653
1.626
1.555
1.587
1.609
Sample B
JY
1.418
3.430
0.999
2.916
2.817
1.979
Table 2: Results of PP Test (Original Series)

Variable
Without Trend
With Trend
Sample A
JY
1.687
1.694
1.630
1.615
1.490
1.468
Sample B
JY
1.282
3.289
1.143
2.628
4.427*
2.373
Note: * indicates significance at 5% level; 5% critical values are 2.89 (without trend) and 3.45 (with trend).
Next, the data with first difference from the original data is analyzed using the ADF and
PP tests. It is possible to conclude that all the variables are I(1). These results are shown in
Tables 3 and 4.
65
Table 3: Results of ADF Test (First Difference Series)

Variable
Without Trend
With Trend
Sample A
JY
19.570*
19.377*
19.169*
18.948*
17.219*
17.120*
Sample B
JY
11.649*
12.185*
11.597*
11.649*
7.991*
8.244*
Note: * indicates significance at 5% level; 5% critical values are 2.89 (without trend) and 3.45 (with trend).
Table 4: Results of PP Test (First Difference Series)

Variable
Without Trend
With Trend
Sample A
JY
19.624*
19.633*
19.222*
19.236*
17.267*
17.276*
Sample B
JY
17.590*
17.591*
17.933*
17.933*
10.366*
10.801*
Note: * indicates significance at 5 % level; 5% critical values are 2.89 (without trend) and 3.45 (with trend).
Cointegration Test3
The results for Sample A show that there is one cointegration relationship among the three
interest rates. As for the results of the pairing tests, Japanese interest rate swaps and Tokyo
Electric Power Company bonds are cointegrated. Thus, it can be said that they moved together
in a long-run equilibrium before the Earthquake.
3
66
When the results of both trace and maximal eigenvalue tests are significant, the two variables are judged to be
in a relationship of cointegration.
The results for Sample B indicate that there is one cointegration relationship among all
three rates. The pair tests also show that Japanese government bonds and Japanese interest
rate swaps were cointegrated, and hence moved together in a long-term equilibrium after the
Earthquake. The results are shown in Table 5.
Table 5: Results of Cointegration Test
Trace Test
Maximal Eigenvalue Test
Critical Value
Null Hypothesis
trace
10%
Critical Value
5%
max
10%
5%
Sample A
JY, Y, E
r=0
40.029**
39.06
42.44
23.325*
23.11
25.54
r1
16.704
22.76
25.32
14.114
16.85
18.96
r2
2.590
10.49
12.25
2.590
10.49
12.25
16.85
18.96
2.754
10.49
12.25
JY, Y
r=0
20.503
22.76
25.32
r1
2.754
10.49
12.25
17.748**
JY, E
r=0
16.875
22.76
25.32
14.371
16.85
18.96
r1
2.505
10.49
12.25
2.505
10.49
12.25
Y, E
r=0
r1
25.003**
2.812
22.76
25.32
22.192*
16.85
18.96
10.49
12.25
2.812
10.49
12.25
Sample B
JY, Y, E
r=0
44.308*
39.06
42.44
26.907*
23.11
25.54
r1
17.401
22.76
25.32
12.361
16.85
18.96
r2
5.040
10.49
12.25
5.040
10.49
12.25
67
Table 5 (Cont.)
Trace Test
Maximal Eigenvalue Test
Critical Value
Null Hypothesis
trace
10%
Critical Value
5%
max
10%
5%
JY, Y
r=0
28.149*
22.76
25.32
22.845*
16.85
18.96
r1
5.304
10.49
12.25
5.304
10.49
12.25
JY, E
r=0
24.137**
22.76
25.32
13.565
16.85
18.96
r1
10.572
10.49
12.25
10.572
10.49
12.25
Y, E
r=0
20.376
22.76
25.32
12.505
16.85
18.96
r1
7.870
10.49
12.25
7.870
10.49
12.25
Note: * and ** indicate significance at 5% and 10% levels, respectively; Critical values are from OsterwaldLenum (1992).
Granger Causality Test

The results for Sample A show that there are no causalities, except for mutual causalities
between the same variables. The results for Sample B show that apart from mutual causalities,
there is also a causal link between Japanese government bonds and Japanese interest rate
swaps (Table 6).
Table 6: Results of Granger Causality Test
Explanatory Variable
Object Variable
JY
Sample A
JY
33.497*
1.264
2.035
0.793
50.788*
0.902
1.693
1.577
19.820*
Sample B
JY
22.454*
2.435*
0.435
3.974*
72.891*
0.163
1.323
1.169
17,734.669*
Note: * indicates significance at 5% level; test statistics are F-values; and the method of Toda and Yamamoto
(1995) is used.
68
Conclusion
This paper focused on the structural changes in the market for long-term interest rates in
Japan before and after the Earthquake by analyzing co-movement and transmission. Japanese
interest rate swaps and Tokyo Electric Power Company bonds moved together before the
Earthquake. This is mainly because they have similar credit qualities, in that they both
represent the private sector. The credit risk of the banking sector is incorporated in interest
rate swaps, and that of private companies with good credit quality in Tokyo Electric Power
Company bonds.
On the other hand, Japanese government bonds and Japanese interest rate swaps moved
together after the Earthquake. The credit quality of the Tokyo Electric Power Company was
downgraded to non-investment grade. For example, Standard & Poors downgraded the
companys credit rating to BB+ on May 31, 2011. Before the Earthquake, we usually considered
the Japanese government bonds, interest rate swaps, and corporate bonds, especially the
Tokyo Electric Power Company bonds, as the benchmarks for long-term interest rates in
Japan. It is clear that the Tokyo Electric Power Company bonds no longer function as such a
benchmark. Thus Japanese government bonds and interest rate swaps are now the benchmarks
for long-term interest rates in Japan since the Earthquake when they began to co-move.
There is no transmission among the three interest rates before the Earthquake. The
mutual transmission between Japanese government bonds and Japanese interest rate swaps is
found after the Earthquake. This supports the suggestion that Japanese government bonds
and interest rate swaps are benchmarks for long-term interest rates in Japan after the
Earthquake, as demonstrated above, together with the result that Japanese government bonds
and Japanese interest rate swaps have moved together since then.
References
1.
Dickey D A and Fuller W A (1979), Distribution of the Estimators for Autoregressive

Time Series with a Unit Root, Journal of the American Statistical Association, Vol. 74,
No. 366, pp. 427-431.
2.
Dickey D A and Fuller W A (1981), Likelihood Ratio Statistics for Autoregressive

Time Series with a Unit Root, Econometrica, Vol. 49, No. 4, pp. 1057-1072.
3.
Engle R F and C W J Granger (1987), Cointegration and Error Correction:

Representation and Testing, Econometrica, Vol. 55, No. 2, pp. 251-276.
4.
Fuller W A (1976), Introduction to Statistical Time Series, John Wiley & Sons, Inc.
5.
Ito T (2009), The Analysis of Co-Movement Between Government Bond and

Interest Rate Swap Markets, Asia-Pacific Journal of Economics and Business, Vol. 3, No. 1,
pp. 14-30.
6.
Ito T (2010), Japanese Interest Rate Swap Spreads Under Different Monetary Policy
Regimes, The IUP Journal of Applied Finance, Vol. 16, No. 1, pp. 57-70.
69
7.
Johansen S (1988), Statistical Analysis of Cointegrated Vectors, Journal of Economic

Dynamics and Control, Vol. 12, Nos. 2 and 3, pp. 231-254.
8.
Morris C, Neal R and Rolph D (1998), Credit Spreads and Interest Rates:
A Cointegration Approach, Federal Reserve Bank of Kansas City Research Working
Paper, RWP 98-08.
9.
Osterwald-Lenum M (1992), Practitioners Corner: A Note with Quantiles of the

Asymptotic Distribution of the Maximum Likelihood Cointegration Rank Test
Statistics, Oxford Bulletin of Economics and Statistics, Vol. 54, No. 3, pp. 461-472.
10.
Phillips P C B (1986), Understanding Spurious Regressions in Econometrics, Journal

of Econometrics, Vol. 33, No. 3, pp. 311-340.
11.
Phillips P C B and Perron P (1988), Testing for a Unit Root in Time Series Regression,
Biometrika, Vol. 75, No. 2, pp. 335-346.
12.
Toda H Y and Yamamoto T (1995), Statistical Inference in Vector Autoregressions

with Possibly Integrated Processes, Journal of Econometrics, Vol. 66, Nos. 1 and 2,
pp. 225-250.
Reference # 01J-2013-10-04-01
70
Forecasting Daily Stock Volatility Using GARCH

Model: A Comparison Between BSE and SSE
Sasikanta Tripathy* and Abdul Rahman**
Modeling and forecasting the volatility of stock markets has been one of the major topics in financial econometrics in
recent years. Based on the daily closing value of 23 years data, an average of 5,605 observations, for both Sensex and
Shanghai Stock Exchange Composite Index, this paper makes an attempt to fit appropriate GARCH model to estimate
the conditional market volatility for both Bombay Stock Exchange (BSE) and Shanghai Stock Exchange (SSE),
respectively. The empirical results demonstrate that there are significant ARCH effects in both the stock markets, and
it is appropriate to use the GARCH model to estimate the process.
Introduction
Given the rapid growth in financial markets over the past 20 years, along with the explosive
development of new and more complex financial instruments, an ever-growing need has
emerged for accurate and efficient volatility forecasting to use in numerous practical
applications of financial data such as the analysis of market timing decisions, assistance in
portfolio selection, and estimates of variance in option pricing models. Furthermore, accurate
volatility estimates are also vital in areas such as risk management for the calculation of
metrics in hedging and Value-at-Risk (VaR) policies.
Since the 1987 stock market crash, modeling and forecasting financial market volatility
has received a great deal of attention from academics, practitioners and regulators due to its
central role in several financial applications, including option pricing, asset allocation and
hedging (Busch et al., 2011). In addition, the financial world has witnessed bankruptcy or
near bankruptcy of various institutions that incurred huge losses due to their exposure to
unexpected market moves for more than a decade (Liu et al., 2009). These financial disasters
have further highlighted the significance of volatility forecasting in risk management
(calculating VaR). Given these facts, the quest for accurate forecasts appears to be still going
on in the recent years.
When volatility is interpreted as uncertainty (Samanta and Samanta, 2007; and Anbarasu
and Srinivasan, 2009), it becomes a key input to many investment decisions and portfolio
creations. Given that investors and portfolio managers have certain bearable levels of risk, a
proper forecast of the volatility of asset prices over the investment holding period is of
paramount importance in assessing investment risk. Volatility forecasting is an area within
which the debate continues, and indeed there is already a wealth of literature on the subject.
*
Research Scholar, VGSOM, Indian Institute of Technology Kharagpur, Kharagpur, West Bengal, India; and is
the corresponding author. E-mail: stripathy.iitkgp@gmail.com
* * Research Scholar, VGSOM, Indian Institute of Technology, Kharagpur, Kharagpur, West Bengal, India.
E-mail: rahman.shaik@gmail.com
2013 IUP.Daily
All Rights
Forecasting
Stock Reserved.
Volatility Using GARCH Model: A Comparison Between BSE and SSE
71
One type of investment instrument that is being extensively adapted in recent years is
Exchange-Traded Funds (ETFs); over the course of a trading day, these instruments, which
hold assets such as stocks or bonds, trade at almost the same price as the net value of the
underlying assets. ETFs are more popular because of their low cost, tax efficiency and stocklike features, with most ETFs tracking an index such as the S&P 500, Dow Jones or NASDAQ100. One of the most widely known ETFs is Standard & Poors Depositary Receipts (SPDRs
or Spider, ticker: SPY), which began trading in January 1993, and which was designed to
closely track the S&P 500 index.
The publication of Engle (1982) introduced Autoregressive Conditional Heteroskedasticity
(ARCH) model to the world. It is used to characterize and model observed time series in
econometrics. There have been some other methods of modeling and forecasting financial
volatility such as the Generalized ARCH model proposed by Bollerslev (1986). It is well
known that financial returns are often characterized by a number of typical stylized facts
such as volatility clustering, studying long-run relationship among time series data, persistence
and time variation of volatility. The Generalized Autoregressive Conditional
Heteroskedasticity (GARCH) genre of volatility models is regarded as an appealing technique
to cater to the aforesaid empirical phenomena. The existing literature has long since recognized
that the distribution of returns can be skewed. For instance, for some stock market indices,
returns are skewed toward the left, indicating that there are more negative than positive
outlying observations. The intrinsically symmetric distribution such as normal, student-t or
Generalized Error Distribution (GED) cannot cope with such skewness. Consequently, one
can expect that forecasts and forecast error variances from a GARCH model may be biased
for skewed financial time series.
The Bombay Stock Exchange (BSE), the oldest exchange in Asia, was the first stock
exchange to be recognized by the Indian government under the Securities Contracts
Regulation Act. The exchange developed the BSE Sensex in 1986, giving the BSE a means to
measure the overall performance of the exchange. In 2000, the BSE used this index to open
its derivatives market, trading Sensex futures contracts. The development of Sensex options
and equity derivatives followed in 2001 and 2002, respectively, expanding the BSEs trading
platform.1
Correspondingly, there are two stock exchanges operating independently in the Peoples
Republic of China: one is Shanghai Stock Exchange (SSE) that is based in the city of Shanghai,
China and the other is Shenzhen Stock Exchange which is based in the city of Shenzhen,
China. Both of them contain the A-shares and B-shares. The SSE was established on December
19, 1990 and the Shenzhen Stock Exchange was established on July 2, 1991. SSE is the worlds
fifth largest stock market. The A-shares in the Shanghai Stock Market employ Chinese Yuan
as the currency and the B-shares allow the US dollar to trade. Like many developing countries,
to sustain the domestic control of local companies, the Chinese government still does not
1
72
http://en.wikipedia.org/wiki/Bombay_Stock_Exchange, BSE India. Retrieved on March 12, 2013.

allow the SSE entirely open to foreign investors. With a short-lived bull, the Chinese stock
markets experienced a nearly five-year long bear market until June 2005, when the reform of
non-tradable shares was implemented, which increased the liquidity and brought the markets
back to a long-term bull run.2
Literature Review
Considering the time-varying behavior of volatility, ARCH model was developed by Engle
(1982), which was further developed into GARCH model by Bollerslev (1986). Since then, a
number of extensions of the basic GARCH model that are especially suited for estimating
the conditional volatility of financial time series have been developed.
Sulin et al. (2007) studied the volatility of Shenzhen stock market by using weekly closing
price, and the results revealed that AR(1) model exhibited the best predicting result, while
AR(2) model exhibited predicting results that are intermediate between AR(1) model and
the logistic regression model. Zunino et al. (2008) evaluated multifractality degree in a
collection of developed and emerging stock market indices. Their results suggest that the
multifractality degree can be used as a quantifier to characterize the stage of market
development of world stock indices from the daily data beginning on January 2, 1995 and
ending on July 23, 2007.
Fuertes et al. (2009) analyzed a 7-year sample of transaction prices for 14 NYSE stocks and
compared estimators like realized volatility, realized range, realized power variation and realized
bipower variation by examining their in-sample distributional properties and out-of-sample
forecast ranking when the object of interest is the conventional conditional variance.
Liu et al. (2009) investigated how the specification of return distribution influences the
performance of volatility forecasting using two GARCH models (GARCH-N and
GARCHSGED) for the daily spot prices on the Shanghai and Shenzhen composite stock
indices from January 4, 2000 to December 29, 2006. The results indicate that the GARCHSGED model is superior to the GARCH-N model in forecasting Chinas stock market volatility
for all forecast horizons.
Liu and Hung (2010) studied the daily volatility forecasting and identified the essential
source of performance improvements between distributional assumption and volatility
specification using distribution-type (GARCH-N, GARCH-t, GARCH-HT and GARCHSGT) and asymmetry-type (GJR-GARCH and EGARCH) volatility models through the
Superior Predictive Ability (SPA) test. The results indicate that the GJR-GARCH model
achieved the most accurate volatility forecasts, closely followed by the EGARCH model for
the Standard & Poors 100 stock index series from 1997 to 2003.
Aal and Ahmed (2011) studied the performance of five models for forecasting the Egyptian
stock market return volatility. The results for the period January 1, 1998 to December 31,
2009, as an in-sample period, show that EGARCH is the best model between the examined
2
http://en.wikipedia.org/wiki/Shanghai_Stock_Exchange, SSE China. Retrieved on March 12, 2013.
Forecasting Daily Stock Volatility Using GARCH Model: A Comparison Between BSE and SSE
73
models according to the usual evaluating statistical metrics (RMSN, MAE, and MAPE), and
when Diebold and Mariano (DM) test was used to examine the significance of the difference
between errors of volatility forecasting models, the results found no significant difference
between the errors of competing models.
The study by Diamandis et al. (2011), covering the daily data of 1987-2009 for three
groups of stock market indices, reconsiders the use of VaR as a measure for potential risk of
economic losses in financial markets by estimating VaR for daily stock returns with the
application of various parametric univariate models that belong to the class of ARCH models
which are based on the skewed student distribution. The results indicate that the skewed
student APARCH model outperforms all other specification modeling VaR for either long or
short positions.
Ou and Wang (2011) studied how the Gaussian processes are applied to model and predict
financial volatility based on GARCH, EGARCH and GJR to capture the symmetric and
asymmetric effects. The results, by using five different kernels to train each of the proposed
volatility model, show that the nonlinear hybrid models can capture well the symmetric and
asymmetric effects of news on volatility and yield better predictive performance than the
classic GARCH, EGARCH and GJR approaches.
Yin et al. (2011) examined the presence of heteroskedasticity and the leverage effect on
the two Chinese stock markets to capture the dynamics of conditional correlation between
the returns of Chinas stock markets and those of the US in a bivariate VCMGARCH
framework during the period 2000-08. The results show that the leverage effect is significant
in both Shanghai and Shenzhen markets, and the conditional correlation between the stock
markets of mainland China and the US is quite low and highly volatile. Also, the results
show that the uncertainty derived from time-varying relationship between Shanghai and
the US stock markets is more significant than that between Shenzhen and the US stock
markets.
Babikir et al. (2012) investigated the empirical relevance of structural breaks in forecasting
stock return volatility using both in-sample and out-of-sample tests applied to daily returns
of the Johannesburg Stock Exchange (JSE) All Share Index. The results for the period July 2,
1995 to August 25, 2010 show evidence of structural breaks in the unconditional variance of
the stock returns series over the period, with high levels of persistence and variability in the
parameter estimates of the GARCH(1, 1) model across the sub-samples defined by the
structural breaks.
Gabriel (2012) evaluated the forecasting performance of GARCH-type models in terms
of daily stock index return data from Romania (BET index), covering the period March 9,
2001 to February 29, 2012. He found that the TGARCH model is the most successful in
forecasting the volatility of BET index and has important significance in the calculation of
Value-at-Risk (VaR) and in the risk management process. Liu et al. (2012) studied four various
GARCH-type models, incorporating the skewed generalized t (SGT) errors into those returns
74
innovations exhibiting fat-tails, leptokurtosis and skewness to forecast both volatility and
VaR for SPDRs. The empirical results from 2002 to 2008 indicate that the asymmetric
EGARCH model is the most preferable according to purely statistical loss functions.
Zhou et al. (2012) studied the directional volatility spillovers between the Chinese and
world equity markets based on Diebold and Yilmazs (2011) forecast-error variance
decompositions in a generalized vector autoregressive framework in two different researches.
The results show that the volatility of Chinese market had a significantly positive impact on
other markets since 2005, and the volatility interactions among the markets of China, Hong
Kong and Taiwan were more prominent than those among the Chinese, Western, and other
Asian markets.
Objectives
The primary objective is to fit an appropriate GARCH model to estimate the conditional
market volatility based on Sensex and SSE Composite Index (SHCOMP) for BSE and SSE,
respectively. More specifically, this paper aims
1. To find out the stationarity of all the closing indices both for Sensex and SHCOMP;
2. To know the return characteristics for both the stock exchanges through descriptive
statistics;
3. To measure the volatility for both the markets; and
4. To make a comparative study between BSE and SSE.
Data and Methodology

The scope of the study is limited to the past 23 financial yearsi.e., January 1, 1990 to
January 31, 2013 (depending upon the availability)data of BSE Sensex and SSE Composite
Index. The daily closing values of both the exchanges have been taken for 5,605 observations.
We have used BSE Sensex as a proxy for the stock market because it is the major valuebased representative of the Indian stock market, and SSE Composite Index, because it is an
important representative of Chinas stock market. The previous research works which have
tested the functional relationship between BSE and SSE are Chen et al. (2006) and Patel et al.
(2012).
The study is based mainly on the secondary data which have been collected from the
official website of BSE (http://www.bseindia.com/) for Sensex and yahoo finance (http://
in.finance.yahoo.com/) for SSE Composite Index.
Various statistical tools, ARCH-LM test, Augmented Dicker Fuller (ADF) test, and
Granger Causality test, are used in the study. An Autoregressive Moving Average (ARMA)
model is assumed for the error variance; the model is a generalized autoregressive conditional
heteroskedasticity (GARCH) Bollerslev (1986) model, which generalizes the ARCH(q) model
to GARCH(p, q) model. Liu and Hung (2010), Ou and Wang (2011), and Yin et al. (2011)
75
have used ARCH and GARCH models to measure volatility. Descriptive statistics provides
simple summaries about the sample and about the observations that have been made. Likewise,
unit root test is done to check the data stationarity as time series data are involved, and the
Granger causality test for determining whether one time series is useful in forecasting another.
These tests are done with the help of statistical software like MS Excel 2007, EViews 7, and
Gretl 1.9.11.
Measurement of Volatility
Volatility, as described, refers to the fluctuation in the daily closing values of BSE and SSE
indices over 23 years. Here volatility has been measured as the standard deviation of the rates
of return. The rates of returns have been computed by taking a logarithmic difference of
prices of two successive periods. Symbolically, it may be stated as follows:
Rt = loge (pt/pt1) = loge (pt) loge (pt)
where loge is the natural logarithm, pt and pt1 are the closing prices for the two consecutive
periods. The logarithmic difference is symmetric between up and down movements and is
expressed in percentage terms. Further, as discussed in the previous research works of Liu and
Hung (2010) that the volatility of returns is categorized by a number of facts such as volatility
clusters, time-varying volatility, and leptokurtic behavior, introduction of GARCH model
of Bollerslev (1986) and Engle (1982) has become an approved tool for modeling volatility
and forecasting.
ARCH and GARCH

ARCH models are used to characterize and model observed time series. They are used whenever
there is reason to believe that at any point in a series, the terms will have a characteristic size
or variance. In particular, ARCH models assume the variance of the current error term or
innovation to be a function of the actual sizes of the previous time periods error terms: often
the variance is related to the squares of the earlier innovations. Engle (1982) suggests that
the conditional variance h can be modeled as a function of the lagged E s, i.e., the expected
volatility is dependent on past news. The model developed was the qth order ARCH model,
which is written as ARCH (q):
h
= W + 1 E t1 + 2E t22 + 1E t1+ ... + q E tq
where
W , 1, ..., q = Parameters to be estimated
h
= Conditional variance at period t
q = Number of lags included in the model

E t = Innovation in return at time t
where W > 0, 1, 2, ..., q > 0.

An ARMA model is assumed for the error variance; the model is a GARCH Bollerslev
(1986) model, which generalized the ARCH(q) model to GARCH(p, q) model, such that:
h
76
= W + 1 E t1 + 2E t22 + 1E t1+ ... + q E tq + 1ht2 + p E tp

where
W , 1, ..., q , 1, ..., p = Parameters to be estimated.
h
= Conditional variance at period t.
q = Number of return innovation lags included in the model.

E t = Innovation in return at time t.
where W > 0, 1, 2, ..., q 0, 1, ..., p 0.

The GARCH(p, q) process defined above is stationary when (1 + 2 + ... + q) + (1 +
2 + ... + p) < 1.

Descriptive investigation of the plot of daily returns on Sensex (Figure 1) and SSE Composite
Index (SHCOMP) (Figure 2) reveals that the returns have continuously fluctuated around
the mean value that was close to zero for both the indices.
Figure 1: Volatility Clustering of Daily Returns
of BSE Sensex (01/01/1990 to 31/01/2013)
0.20
0.15
0.10
0.05
0
0.05
0.10
0.15
0.20
Figure 2: Volatility Clustering of Daily Returns

of SSE SHCOMP (19/12/1990 to 31/01/2013)
0.6
0.5
0.4
0.3
0.2
0.1
0
0.1
0.2
0.3
77
The return measures were both in positive and negative area. In comparison to SSE, BSEs
volatility is more; but initially the former volatility was more as depicted from figures. From
the time series graph of the returns for both BSE Sensex and SSE SHCOMP, it is analyzed
that high volatility is followed by high volatility, and likewise low volatility is followed by
low volatility. That means time series has important time-varying variances. Additionally, it
is simply to put conditional variance into the function to clarify the impact of risk on the
returns. Hence, GARCH model is the estimable tool for the study. This is similar to the study
of Yin et al. (2011).
Descriptive statistics on Sensex and SHCOMP returns are summarized in Table 1. For
both Sensex and SHCOMP, the skewness statistics for daily return is found to be different
from zero, indicating that the return distribution is not symmetric, but for the latter, it is
more asymmetric in comparison to the former. Furthermore, the relatively large excess kurtosis
suggests that the underlying data are leptokurtic or heavily tailed, and sharply peaked about
the mean when compared with the normal distribution, which is more in the case of SHCOMP
as compared to Sensex. The Jarque-Bera statistics calculated to test the null hypothesis of
normality rejects the normality assumption. The results authenticate the well-known fact
that daily stock returns are not normally distributed but are leptokurtic and skewed, which
depicts the volatility nature of stock markets. The existence of a leptokurtic distribution and
presence of volatility clustering suggest an ARCH or GARCH process, which was confirmed
in Table 2 by computing the value of Lagrange Multiplier (LM) which rejects the null
hypothesis. The results of the current study are similar to that of Ou and Wang (2011), where
Table 1: Descriptive Statistics of Daily Returns
Basis
BSE
SSE
Jan. 1, 1990 to Jan. 31, 2013
Jan. 1, 1990 to Jan. 31, 2013
5,515
5,694
Mean
0.000427
0.000278
Median
0.000943
0.000016 (1.64E-05)
Maximum
0.147771
0.512835
Minimum
0.146378
0.196082
SD
0.017888
0.022938
Skewness
0.266102
2.425314
Kurtosis
8.561271
59.64189
7170.721 (2-tailed p =0.00)
766617.6 (2-tailed p =0.00)
Observation Period
Number of Observations
Jarque-Bera
78
Table 2: Descriptive Statistics of ARCH-LM Test (at Lag = 1) for Daily Returns
Distribution
BSE
SSE
Normal
0.2502
0.9783
Students t
0.3085
0.886
Generalized Error Distribution (GED)
0.2612
0.7652
Note: ARCH-LM test statistics is the Lagrange Multiplier test statistic for the presence of ARCH. Under the
null hypothesis of no heteroskedasticity, it is distributed as a chi-square.
they remarked that their facts suggest a highly competitive and volatile market. To sum up,
the analysis indicates that the market return is non-normal, and exhibits ARCH effect.
Unit Root Tests

The presence of unit root in a time series is tested with the help of ADF test. It tests for a unit
root in the univariate representation of time series. For a return series yt, the ADF test
consists of a regression of the first difference of the series against the series lagged t times as
follows:
yt t yt 1 1yt 1 ... p1yt p 1 t

where is a constant, the coefficient on a time trend and p the lag order of the autoregressive
process. Here, imposing the constraints = 0 and = 0 corresponds to modeling a random
walk and using the constraint = 0 corresponds to modeling a random walk with a drift. The
null hypothesis is H0: = 0 and H1: < 1. The acceptance of null hypothesis implies nonstationarity.
Here, the calculated p-values of ADF were less than 0.005 which leads to the conclusion
that the data of the time series under the study are stationary. The results of both the tests
confirm that the series are stationary (Table 3).
Table 3: Unit Root Testing of Daily Returns
BSE
Augmented Dickey-Fuller
Test Statistics
Test Critical Values:
SSE
t-Statistic
Prob.
t-Statistic
Prob.
68.2007
0.0001
72.7568
0.0001
1% Level
3.431356
3.431319
5% Level
2.861869
2.861853
10% Level
2.566988
2.566979
Source: Calculated from the data taken from BSE and Yahoo Finance websites for the selected period
79
Fitting ARCH and GARCH

We use GARCH(1, 1) model which is the most popular of the ARCH family to model the
volatility of BSE returns and SSE composite returns. Further, three types of distributions are
used in this study to test the robustness of the results. They are, Normal Gaussian Distribution,
Students t with fixed degrees of freedom and GED (see Table 4).
Table 4: ARCH and GARCH Model
Market Distribution Constant
BSE
SSE
ARCH
GARCH Adjusted
( )
AIC
SC
(w)
()
Normal
4.74E-06
0.114794
0.874623 0.000555 5.512662 5.507863
Students t
4.97E-06
0.114481
0.870672 0.000777 5.548297 5.543498
GED
4.82E-06
0.114605
0.873691 0.000868 5.540064 5.534065
Normal
6.17E-06
0.145674
0.852254
Students t
6.21E-06
0.132861
0.84229
GED
9.22E-06
0.180052
0.814731 0.000138
5.260705 5.256035
0.000134 5.438725 5.434054

5.48526 5.479422
Source: Compiled from EViews 7 for the data taken from BSE and Yahoo Finance websites
Under the three distributions mentioned above, both ARCH and GARCH are significant,
which means that the previous days information of return on BSE and SSE composite (that
is ARCH) can influence todays volatility. Similarly, the previous days volatility of BSE and
SSE composite (that is GARCH) can influence todays volatility. This means that BSE and
SSE composite return volatility is influenced by its own ARCH and GARCH factors or own
shocks. Moreover, the return volatility of SSE composite is more influenced by its previous
days information than BSE.
From Table 4, one can observe that for both the markets BSE and SSE composite
GARCH(1, 1) under normal distribution has relative high adjusted R2 than other distributions.
Moreover, from the standard of AIC and SC criterion, the model under normal distribution
has the lowest value. This shows that GARCH(1, 1) model is a good model for the estimation
and forecasting of volatility. The results are similar to that of Liu and Hung (2010), where
they documented that the GARCH model obtains the most accurate volatility forecasts.
Further, it is found that for both the markets under all the distribution methods, the values
of are close to 1. This documents that there is high durability of the volatilities in both the
markets which means that the sharp movements will persist for a long time even if there are
expected shocks. Similarly, the current study also found that the summation of and is less
than 1 under all the distributions, which indicates that the GARCH(1, 1) process for the
stock return is, in a wide sense, stationary. Moreover, leverage effects are present in both the
80
markets, i.e., the volatilities caused by negative shocks are greater than that caused by positive
shocks. This finding is similar to that of Gabriel (2012), where he also documented the
presence of leverage effects. Also, one can observe that the two exchanges taken in this study
are highly correlated and there is a considerable coexistence in their movements. This might
be due to the fact that these two stock exchanges are situated in emerging countries like India
and China.
Forecasts of Market Volatility

Once the model has been fitted to market returns, it can be used to forecast volatility. We use
the following model to forecast volatility for one day ahead:
ht = w + 1 wt12 + 1 ht1
The estimates for BSE are as follows:
ht
= 4.74E-06 + 0.114794 wt12 + 0.874623 ht1
Students t: ht
= 4.97E-06 + 0.114481 wt12 + 0.870672 ht1
GED:
= 4.82E-06 + 0.114605 wt12 + 0.873691 ht1
Normal:
ht
The estimates for SSE are as follows:

Normal:
ht
= 6.17E-06 + 0.145674 wt12 + 0.852254 ht1
Students t: ht
= 6.21E-06 + 0.132861 wt12 + 0.84229 ht1
GED:
= 9.22E-06 + 0.180052 wt12 + 0.814731 ht1
ht
Based on these estimates of returns for both BSE Sensex and SSE SHCOMP, it is observed
that high volatility is followed by high volatility, and low volatility is followed by low volatility.
The descriptive statistics indicated that the daily stock returns are not normally distributed
but are leptokurtic and skewed, which depicts the volatility nature of stock markets.
These findings suggest that the Indian stock markets have significant ARCH effect and
hence it is appropriate to use GARCH models to estimate the forecasting volatility process.
We use GARCH(1, 1) model, the most popular member of the ARCH class of models, to
model volatility of Sensex returns. The model with large value of lag coefficient (+0.875 for
BSE and +0.853 for SSE) shows that the volatility in both the stock markets is highly
persistent, i.e., long memory and is predictable. The relatively small value of error coefficient
for BSE (+0.115), in comparison to SSE (+0.146) of GARCH(1, 1), implies that market
surprises include relatively small revisions in future volatility.
Conclusion
Stock market volatility has many implications for the real economy. Forecasting stock market
is essential in finance areas such as option pricing, VaR applications and selection of a portfolio.
81
Empirical results demonstrate that in both the stock markets, there are significant ARCH
effects and it is appropriate to use the GARCH model to estimate the process. The results of
the current study are similar to those of Liu and Hung (2010), Ou and Wang (2011), Yin et al.
(2011), and Gabriel (2012). These findings have important implications for the investors
seeking opportunity for portfolio diversification.
References
1.
Aal A E and Ahmed M (2011), Modeling and Forecasting Time Varying Stock Return
Volatility in the Egyptian Stock Market, International Research Journal of Finance and
Economics, No. 78, pp. 96-113.
2.
Anbarasu D J and Srinivasan S (2009), Price Volatility: An Evaluation of the Indian

Stock Market During Global Financial Crisis, The IUP Journal of Financial Risk
Management, Vol. 6, No. 2, pp. 7-25.
3.
Babikir A, Gupta R, Mwabutwa C and Owusu-Sekyere E (2012), Structural Breaks and

GARCH Models of Stock Return Volatility: The Case of South Africa, Economic
Modelling, Vol. 29, No. 6, pp. 2435-2443.
4.
Bollerslev T (1986), Generalized Autoregressive Conditional Heteroskedasticity,

Journal of Econometrics, Vol. 31, No. 3, pp. 307-327.
5.
Busch T, Christensen B J and Nielsen M O (2011), The Role of Implied Volatility in

Forecasting Future Realized Volatility and Jumps in Foreign Exchange, Stock, and Bond
Markets, Journal of Econometrics, Vol. 160, No. 1, pp. 48-57.
6.
Chen H, Lobo B J and Wong W-K (2006), Links Between the Indian, US and Chinese
Stock Markets, Working Paper, Department of Economics, National University of
Singapore, pp. 1-27, available at http://nt2.fas.nus.edu.sg /ecs/pub/wp/wp0602.pdf.
Accessed on April 8, 2013.
7.
Diamandis P F, Drakos A A, Kouretas G P and Zarangas L (2011), Value-at-Risk for

Long and Short Trading Positions: Evidence from Developed and Emerging Equity
Markets, International Review of Financial Analysis, Vol. 20, No. 3, pp. 165-176.
8.
Diebold F X and Yilmaz K (2011), Better to Give Than to Receive: Predictive

Directional Measurement of Volatility Spillovers, International Journal of Forecasting,
Vol. 28, No. 1, pp. 57-66.
9.
Engle R F (1982), Autoregressive Conditional Heteroscedasticity with Estimates of

the Variance of United Kingdom Inflation, Econometrica, Vol. 50, No. 4, pp. 987-1007.
10.
Fuertes A-M, Izzeldin M and Kalotychou E (2009), On Forecasting Daily Stock

Volatility: The Role of Intraday Information and Market Conditions, International
Journal of Forecasting, Vol. 25, No. 2, pp. 259-281.
82
11.
Gabriel A S (2012), Evaluating the Forecasting Performance of GARCH Models:

Evidence from Romania, Procedia-Social and Behavioral Sciences, Vol. 62, pp. 1006-1010.
12.
Liu H, Lee Y and Lee M (2009), Forecasting China Stock Markets Volatility via
GARCH Models Under Skewed-GED Distribution, Journal of Money, Investment and
Banking, No. 7, pp. 5-15.
13.
Liu H, Chiang S and Cheng N Y (2012), Forecasting the Volatility of S&P Depositary
Receipts Using GARCH-Type Models Under Intraday Range-Based and Return-Based
Proxy Measures, International Review of Economics and Finance, Vol. 22, No. 1, pp. 78-91.
14.
Liu H-C and Hung J-C (2010), Forecasting S&P-100 Stock Index Volatility: The Role
of Volatility Asymmetry and Distributional Assumption in GARCH Models, Expert
Systems with Applications, Vol. 37, No. 7, pp. 4928-4934.
15.
Liu H-C, Lee M-C and Chang C-M (2009), The Role of SGT Distribution in Valueat-Risk Estimation: Evidence from the WTI Crude Oil Market, Investment Management
and Financial Innovations, Vol. 6, No. 1, pp. 86-95.
16.
Ou P and Wang H (2011), Modeling and Forecasting Stock Market Volatility by

Gaussian Processes based on GARCH, EGARCH and GJR Models, Proceedings
of the World Congress on Engineering, pp. 1-5, Vol. 1, July 6-8, UK.
17.
Patel N, Radadia N and Dhawan J (2012), An Empirical Study on Weak-Form of

Market Efficiency of Selected Asian Stock Markets, Journal of Applied Finance & Banking,
Vol. 2, No. 2, pp. 99-148.
18.
Samanta P and Samanta P K (2007), Impact of Futures Trading on the Underlying

Spot Market Volatility, The IUP Journal of Applied Finance, Vol. 13, No. 10, pp. 52-65.
19.
Sulin P, Feiqi D and Yanming W (2007), A Comparison of Forecasting Models of the

Volatility in Shenzhen Stock Market, Acta Mathematica Scientia, Vol. 27B, No. 1,
pp. 125-136.
20.
Yin Z, Tsui A K and Zhang Z Y (2011), Modeling the Conditional Heteroscedasticity

and Leverage Effect in the Chinese Stock Markets, 19th International Congress on
Modeling and Simulation, Perth, Australia, December 12-16, pp. 1338-1344, available
at http://mssanz.org.au/modsim2011. Accessed on April 6, 2013.
21.
Zhou X, Zhang W and Zhang J (2012), Volatility Spillovers Between the Chinese and
World Equity Markets, Pacific-Basin Finance Journal, Vol. 20, No. 2, pp. 247-270.
22.
Zunino L, Tabak B M, Figliola A et al. (2008), A Multifractal Approach for Stock

Market Inefficiency, Physica, Vol. 387, No. 26, pp. 6558-6566.
Reference # 01J-2013-10-05-01
83
The Performance of Initial Public Offerings

Based on Their Size: An Empirical Analysis
of the Indian Scenario
L Ganesamoorthy* and H Shankar**
The study focuses on the performance of Initial Public Offerings (IPOs) made by the Indian companies on the basis
of the IPO size. A sample of 219 IPOs made by the Indian companies during the period 2001 to 2010 was considered
for the study. Using standard event study methodology, an event window was constructed for a period of 75 days from
the date of listing of securities in the stock market. To eliminate market factors, market-adjusted return was calculated
by deducting the market return from the actual return of shares. The size of issues was classified as small, medium and
large. The results revealed that the performance of large-size IPOs was better than that of small and medium-size
IPOs. The results further revealed that small-size IPOs were overpriced than medium and large-size IPOs.
Introduction
Equity issues are made on the basis of market conditions. If the market perceives that a
company will continue to have good earnings in future, the market price of the companys
share will remain at the same level or will go up. On the other hand, if the market doubts
about the future earnings capacity of the company, it may place lesser value on its share price.
Of course, any new investments made for expanding a business bear results only after a short
gestation period, extending sometimes to a few years. These aspects would of course be
considered by the market and the prices get normalized over a period of time. How quick the
market adjusts the price, factoring in the new information would reveal the efficiency of the
market. Hence, this aspect was studied with regard to the companies which made Initial
Public Offerings (IPOs) during the study period. From the market point of view, it is essential
to know how the market reacts to the IPOs of the Indian companies.
The price fixation of shares at the time of issue is important because it is considered to
have a long-term impact on the market value determination of these shares. There are a
number of instances where high prices are fixed for IPOs, with the prices going down subsequent
to listing, causing heavy losses for the initial investors. Earlier studies have documented that
in certain cases price recovery up to the IPO level was not attained even after two years of
issue, indicating heavy overpricing of issues.
Companies may issue shares to public either under fixed price method or book-building
method or under a combined method. Under fixed price method, the offer price for the
securities is fixed and is intimated to the investors in advance. Under book-building method,
*
Assistant Professor in Commerce, Annamalai University, Annamalainagar 608002, Chidambaram, Tamil Nadu,
India. E-mail: lganesh_cdm@yahoo.co.in
**
Professor and Head, Department of Commerce, Annamalai University, Annamalainagar 608002, Chidambaram,
Tamil Nadu, India. E-mail: dr.hshankar@ymail.com
2013 IUP. All Rights Reserved.

84
the issue price is not fixed or intimated in advance. Companies offer shares at a range of price
which is referred to as a price band, and within this price band the investors are allowed to
bid. The final price of the security is determined only after the closure of the bidding.
The issuing company nominates a lead merchant banker as book runner, who fixes the
price band on the basis of existing market conditions and past performance of the company.
The issuing company appoints a syndicate of members to receive orders from the investors
for the issue. After appointing them, they open bidding. The bidding is open for at least 5
days. The book runners determine the final price of the issue on the basis of the demand at
various price levels in the bid. Finally, allocation is made to the successful bidders and others
get refund order from the issuing company.
The study analyzes the price efficiency of the companies issuing IPOs on the basis of the
size of issue to verify whether size-wise distinction could be made in the efficiency of pricing
of IPOs.
Literature Review
There are various studies on IPO performance in the Indian context as well as in the
international context. However, it is observed that the studies related to IPO size in the
Indian context are limited, especially during the study period of the present study.
Jagadeesh et al. (1993) found a positive relationship between underpricing of IPOs and the
probabilities of size of subsequent seasoned offerings. The researchers evidenced that many
firms which recorded high return on the IPO date went for further issues within three years
of the IPO. Page and Reyneke (1997) found long-run underperformance of South African
IPOs by testing the timing of IPOs in the Johannesburg Stock Exchange. They also found
that the degree of underperformance was associated with the size and nature of the companies.
Companies which made small issues had greater evidence of underperformance than the
large-issue companies. Jaitly (2004) examined the pricing of new issues and their after issue
performance in the Indian context. The results indicated that pricing of new issues appeared
to be consistent with rational decision making. Sohail and Nair (2007) examined the shortrun and long-run performance of IPOs of Pakistani firms. The study found an average of
35.66% underpricing. They evidenced that the size, uncertainty, market capitalization and
oversubscription determined the level of underpricing.
Chopra (2009) investigated the price performance of Indian IPOs and documented the
existence of underpricing in the National Stock Exchange, which was severe in the short
run. Further, it was observed that the initial returns of Indian IPOs were influenced by the
subscription level, listing lead time, size of issue and age. Eswaran (2009) analyzed the postlisting price movement of IPOs and found that though the sentiments of the secondary
market played a vital role in the post-listing gains, the major deciding factors were the
performance of the economy of the country, industry and individual companies. Murugesu
and Santhapparaj (2009) found that underpricing of IPOs in Malaysia was not influenced by
market conditions. The study also found that market prices of IPOs were efficient in early
trading.
85
Islam et al. (2010) analyzed the level of underpricing of IPOs in Bangladesh. The researcher
documented that the degree of underpricing was positively associated with the age of the firm
and firm size and was negatively associated with the type of industry and size of offer. The
study also documented that the timing of offer did not have significant influence on the
degree of underpricing. Zhou and Zhou (2010) tested the activities, pricing and market cycle
of Chinese IPOs. They documented that firm age and board size had a positive impact on IPO
pricing, while offer price and offer size had a negative impact on underpricing.
Objectives
The main objectives of the paper are:
1. To study the price impact of IPOs on the basis of their size; and
2. To study the persistence of price impact of IPOs on the basis of their size.
Data and Methodology

The study covered a period of 10 years from 2001 to 2010. A sample of 219 IPOs made during
the period of the study was selected. The list of IPOs was collected from the PROWESS
database. The share prices of the selected companies and the market index were collected
from the official website of Bombay Stock Exchange (BSE).
To know the performance of IPOs on the basis of size of issues, the sample companies were
divided into three groups: small, medium and large. For this purpose, mean and median were
calculated for the amount of issue of all the sample 219 companies. As the mean stood at 95
cr, issues up to 100 cr were considered as small issues, and as the median stood at 337 cr,,
issues from 101 cr to 350 cr were grouped as medium-size issues, and issues above 350 cr
were classified as large issues. As there was no standard norm for classifying the size, this
methodology was adopted to arrive at the size classification. It was observed that there were
114 small-size issues, 71 medium-size issues and 34 large-size issues during the study period.
Event Study Methodology

IPOs are made on a particular day, but it takes some days to list the stocks on the stock
exchanges. The shares could be traded in the market only after listing, and the market value
of the shares would be available only from that day onwards. Hence the date on which the
shares are listed in the stock market is considered as the IPO date. For the purpose of the
analysis, event study methodology proposed by Henderson (1990) is applied. Event day is
considered as the day in which a major event happened in a particular company. Under this
methodology, an event window is to be framed which consists of certain number of days
before the event day and the same number of days after the event day. Studying price
movements during the event window would help in assessing the impact.
To study the pricing efficiency, the change in the market value of the shares subsequent to
IPO has to be assessed. But as it is known, change in market prices may occur due to change
in general economic conditions and industry-related conditions, which is referred to as
general market factors which affect the prices of all the shares in the market. Another set of
86
factors is specific company related, which is due to change in the company-related information.
To assess the impact of the specific event identified (here IPO is the event) on the priceof the
shares, the changes in price over the previous trading day is to be taken. Such change may be
due to the particular event and general market-related factors. For the purpose of knowing
the changes caused by the particular event, the changes caused by general market-related
factors need to be therefore eliminated. The resulting change is referred to as market-adjusted
return. In other words, market-adjusted return would reflect the change in the value of shares
exclusively due to company-related factors.
The share price index of BSE 500 is considered for the study to reflect the changes in the
general market factors. To exclude market effect on returns, the market return is deducted
from actual return, which is termed as market-adjusted return and is also called Abnormal
Return (AR). Average Abnormal Return (AAR) is the average of all share returns for each
day of the event window.
In event study methodology, an event window is to be framed consisting of certain number
of days prior to the event day and the same number of days after the event day. For those days,
AARs are calculated with the help of selected share prices and market index. However, for
the event of IPO, prior share prices are not available. Hence, an event window is framed
considering 75 days only after the event date and AARs were calculated for those days on a
daily basis. AARs were calculated by subtracting market returns from actual returns of
respective stocks and are also called market-adjusted returns.
In order to calculate AR, actual return of respective stock and return on market index
were calculated as:
Rm
Mt Mt 1
100
Mt
where Mt = market return at day t.
Rj
R jt R jt 1
R jt
100
where Rjt = actual return of security j at day t.

AR was calculated as,
AR jt R jt R mjt
where
Rjt
= actual return of security j at day t;
Rmjt = market return at day t.

87
The AAR of shares on a particular day t is calculated as,
AARt
1 N
AR jt AR j1 AR j2 AR j 3 ... AR jN N
N j 1
where N denotes the number of securities considered for day t.

Cumulative Average Abnormal Returns (CAAR) were also calculated for analyzing the
persistent effect on the price. CAARs are the sums of daily AARs during the event window.
CAAR t
AAR
t k
t-Test for Abnormal Returns

The AAR and CAAR were calculated for Indian IPOs for the study period. In order to check
the efficiency of market, student t-test has been applied (two-tailed) to know the significance
of AAR.
An estimator of can be constructed from the cross-sectional variance of the ARs in
period t and is denoted by:
St
1
N 1
AR
N
j 1
jt
AAR t
where
N
= Number of IPOs considered;
ARjt = Abnormal Return of company j at time t; and

AARt = Average Abnormal Return of particular day t.
The above yields the following test statistic for the AARs.
t N
AAR t
~ t N 1
St
The study follows students t-test with N 1 degrees of freedom and approximate standard
normal distribution. The assumptions of the central limit theorem states that N times the
average divided by standard deviation causes the standard normal random variable.
t N
88
AAR t
N 0,1
St
t-Test for Cumulative Abnormal Returns

For the purpose of testing the significance of AARs in the constructed event window around
t = 0, CAARs over the event window are tested for their significance.
The standard deviation is calculated as
1
N 1
St
CAR
jt
CAAR t
j 1
where
N
= Number of IPOs considered for the study;
CARjt
= Cumulative Abnormal Return of share j at time t; and
CAARt
= Cumulative Average Abnormal Return of day t.
The test statistics is
t N
CAAR t
N 0,1
St

Table 1 shows the AARs of companies which had made small-size issues during the event
window of 75 days. These IPOs had slightly more than 1% return on the first day of trading
(1.0234), but were not statistically significant. They generated very high negative AR on 3rd
day at 1.1801%, which was statistically significant at 5% level. Major spurts in negative
returns during the event window are seen in the 8th, 16th, 20th, 23rd, 31st, 39th, 46th, 54th, 60th and
62nd days. Among the significant returns, the positive return on 45th day was the highest with
0.9258% and was significant at 5% level. The significant AARs of small issues were spread
over the event window. The negative AARs on 23rd and 39th days were 1.0570 and 0.8270%,
respectively, significant at 1% level. AAR on 31st day (0.5652%) was significant at 10% level
and AARs of all other days were significant at 5% level. In the 75-day event window, the
companies with small-size issues experienced over 1% return for three days, of which return
for one day was positive and returns for the other two days were negative. It was observed that
the AARs for only 15 days were statistically significant at different levels of significance.
These issues experienced positive returns for 24 trading days and negative returns for 51 days.
Only on one day, the AAR was more than 1% positive, but on two days, it had a negative
return with more than 1%. It was also observed that there were more than half a percent
positive returns (but less than 1%) for three trading days. But on 17 days, there were over half
a percent negative returns. On the remaining 52 days, AARs were less than half a percent, of
which 20 were positive and 32 were negative.
89
Table 1: AAR and CAAR of Small-Sized IPOs

Day
AAR%
t-Value
CAAR%
t-Value
Day
AAR%
t-Value
CAAR%
t-Value
1.0234
1.4151
1.0234
1.4151
39
0.8270
2.7178a
9.9254
2.7471a
0.3271
0.4862
0.6964
0.7001
40
0.4277
1.4148
10.3531 2.8938a
1.1801
2.1986b
0.4837
0.4145
41
0.3464
1.0454
10.6995 2.9658a
0.4595
0.8017
0.9432
0.6795
42
0.2273
0.6890
10.9268 2.9876a
0.8755
1.5875
1.8187
1.1871
43
0.2607
0.6454
10.6661 2.8720a
0.4060
0.7942
2.2247
1.3279
44
0.0184
0.0450
10.6477 2.7887a
0.6637
1.3494
2.8884
1.6206
45
0.9258
2.0313b
9.7219
0.9971
1.9972b
3.8855
2.0589b
46
0.8198
2.1540b
10.5417 2.6895a
0.4319
0.8829
4.3174
2.1546b
47
0.0971
0.3012
10.4447 2.6121a
10
0.0526
0.1260
4.3701
2.0736b
48
0.6751
2.3960b
11.1198 2.7358a
11
0.5209
1.2519
4.8909
2.2416b
49
0.2829
0.8275
11.4026 2.7632a
12
0.3425
0.7070
4.5485
2.0529b
50
0.4288
1.1786
10.9738 2.6390a
13
0.0450
0.1103
4.5935
2.0228b
51
0.2120
0.6763
11.1858 2.6791a
14
0.0687
0.1672
4.6622
1.9343c
52
0.7079
2.4205b
11.8937 2.8414a
15
0.5992
1.4125
5.2615
2.1980b
53
0.1383
0.4170
12.0321 2.8784a
16
0.7786
2.1153b
6.0400
2.4745b
54
0.8294
2.5722b
12.8614 3.0678a
17
0.3326
0.8707
6.3726
2.4974b
55
0.0468
0.1219
12.8146 3.0691a
18
0.2259
0.4685
6.1467
2.3159b
56
0.3787
1.3698
13.1933 3.1545a
19
0.1755
0.4646
5.9711
2.2105b
57
0.1416
0.4555
13.3349 3.1798a
20
0.7919
2.3219b
6.7630
2.4025b
58
0.2233
0.7167
13.5582 3.2033a
21
0.8105
2.0450b
5.9525
2.1014b
59
0.0312
0.1050
13.5894 3.1880a
22
0.3012
0.9555
6.2538
2.1448b
60
0.6766
2.3929b
14.2660 3.3610a
23
1.0570
3.0467a
7.3108
2.5037b
61
0.3012
1.0141
13.9648 3.3142a
90
2.5113b
Table 1 (Cont.)
Day
AAR%
t-Value
CAAR%
t-Value
Day
AAR%
t-Value
CAAR%
24
0.6322
1.3855
7.9429
2.6402a
62
0.6659
2.2759b
14.6307 3.4649a
25
0.3026
0.7487
7.6404
2.5146b
63
0.1729
0.5821
14.8036 3.4781a
26
0.0784
0.2111
7.7188
2.5033b
64
0.0434
0.1208
14.7602 3.4505a
27
0.4098
1.2510
8.1285
2.5815a
65
0.2321
0.6421
14.9923 3.4898a
28
0.5037
1.5851
8.6323
2.7368a
66
0.6306
1.5963
14.3617 3.2836a
29
0.2264
0.6738
8.8586
2.7662a
67
0.3554
1.0975
14.7170 3.3559a
30
0.0024
0.0071
8.8610
2.7282a
68
0.3496
0.9872
15.0667 3.4231a
31
0.5652
1.6543c
9.4262
2.8655a
69
0.4136
1.1990
14.6531 3.2918a
32
0.0091
0.0237
9.4353
2.8405a
70
0.2095
0.6476
14.8625 3.3101a
33
0.2204
0.4972
9.2148
2.7510a
71
0.0409
0.1169
14.8217 3.2728a
34
0.0589
0.1862
9.1560
2.6845a
72
0.2163
0.5710
15.0379 3.3051a
35
0.0465
0.1257
9.1095
2.6497a
73
0.0317
0.1179
15.0697 3.2558a
36
0.1539
0.3995
9.2634
2.6458a
74
0.2837
0.7840
14.7860 3.1553a
37
0.0936
0.2408
9.1698
2.5528b
75
0.2230
0.6356
14.5630 3.0602a
38
0.0714
0.1698
9.0984
2.5419b
t-Value
Note: a, b, c indicate significance at 1%, 5% and 10% levels, respectively.
The results of CAARs of small-size issues of IPOs showed that on the first day of trading,
positive return was documented, but was not statistically significant. The CAAR for first
seven days were not significant. For the remaining 68 days, they were significant at different
levels. It was observed that the CAAR of small-size issues showed a decreasing trend. CAAR
reached over 4% negative on 9th day of trading and continued up to 14th day, which decreased
further to more than 5% negative on 15th day, and up to 22nd day it fluctuated between 5% and
6% negative. CAAR reached 8% negative on 27th day and continued for three trading days.
Due to a high negative return (0.5652%) on 31st day, CAAR reached 9% and continued for
eight trading days up to 39th day. Though there were continuous positive AARs from 33rd to
38th day (except on 36th day), due to high negative AAR on 39th day (0.8270%), CAAR
increased to over 10% negative. On 45th trading day, there was around 1% positive return and
due to the high positive return, CAAR declined and was at around 9% on that day.
91
In 75 days event window, negative AARs were reported for 51 days and this resulted in a
continuous increase in CAAR over the period of the event window. Negative CAAR was at
14.5630% on the last day of the event window. Hence, it can be stated that the IPOs of smallissue size were highly overpriced.
The results of the AAR of companies with medium-size issues (Table 2) show that positive
returns were observed for 29 days and negative returns for 46 days. A major spurt in the
negative returns was seen on the 3rd, 8th, 11th, 17th, 33rd, 35th, 38th, 44th and 71st days. The
medium-size issue companies experienced more than 1% positive AAR only on one day and
over 1% negative return on two days. It was also observed that these companies had over half
a percent positive return on four days, and over half a percent (but below 1%) negative
returns for 12 trading days. On the remaining 56 days, AARs were less than half a percent, of
which, 24 were positive and 32 were negative.
Medium-size IPOs had positive AAR on the first day of trading at 1.9069% and was
statistically significant at 10% level. It was higher than the small and large-size issue
companies. Its second-day return was also positive, but was not statistically significant. On
the third day, it had a negative AAR of more than 1% (1.6141%) which was significant at
1% level. AARs for nine trading days of the event window were statistically significant.
Among them, the return was positive only on the first day, and on all other days it was
Table 2: AAR and CAAR of Medium-Sized IPOs
Day
AAR%
t-Value
CAAR%
t-Value
Day
AAR%
t-Value
CAAR%
t-Value
1.9069
1.8265c
1.9069
1.8265c
39
0.2683
0.5624
5.6498
1.5236
0.3416
0.4831
2.2485
1.7987c
40
0.5981
1.6302
6.2478
1.6807c
1.6141
2.7730a
0.6344
0.4957
41
0.5000
1.1585
6.7479
1.8315c
0.3739
0.6044
0.2605
0.1670
42
0.0315
0.0831
6.7793
1.8228c
0.0392
0.0840
0.2997
0.1833
43
0.4786
1.2765
6.3008
1.7249c
0.0637
0.1282
0.2360
0.1337
44
0.6997
2.2175b
7.0005
1.9528c
0.7451
1.2388
0.9811
0.5236
45
0.4475
1.4309
7.4480
2.0666b
1.1706
2.8462a
0.1895
0.0996
46
0.2950
0.7652
7.7430
2.1116b
0.6718
1.4955
0.8613
0.4153
47
0.1196
0.2759
7.6235 2.1149 b
10
0.3146
0.5183
0.5467
0.2447
48
0.5953
1.3351
7.0282
1.9093c
11
0.7451
1.7332c
1.2918
0.6072
49
0.1190
0.3653
7.1472
1.8859c
12
0.2828
0.7280
1.5747
0.7166
50
0.0699
0.1884
7.2171
1.8596c
92
Table 2 (Cont.)
Day
AAR%
t-Value
CAAR%
t-Value
Day
AAR%
t-Value
CAAR%
t-Value
13
0.4041
0.9908
1.9787
0.8536
51
0.0631
0.1898
7.1540
1.8156c
14
0.1147
0.1797
2.0935
0.8145
52
0.1432
0.3700
7.0107
1.7196c
15
0.0035
0.0095
2.0899
0.8008
53
0.2111
0.5361
7.2218
1.7405c
16
0.3563
0.7718
2.4462
0.9370
54
0.7158
1.4505
7.9376
1.8924c
17
0.9177
2.1067b
3.3639
1.2568
55
0.5577
1.3065
8.4953
1.9732b
18
0.3490
0.8225
3.7128
1.3759
56
0.3130
0.7951
8.8083
2.0381b
19
0.0655
0.1255
3.6473
1.3472
57
0.4523
1.0197
8.3560
1.9258c
20
0.1788
0.3828
3.4684
1.2130
58
0.4176
0.7751
7.9384 1.8239 c
21
0.1512
0.4062
3.6197
1.2203
59
0.2715
0.7059
7.6669 1.7775 c
22
0.1653
0.3535
3.7850
1.2804
60
0.2553
0.5205
7.4117 1.7411 c
23
0.1725
0.3462
3.6126
1.2145
61
0.6654
1.3617
6.7463
1.5290
24
0.0640
0.1678
3.6766
1.2191
62
0.3334
0.8716
6.4129
1.4457
25
0.0247
0.0591
3.7013
1.2137
63
0.4451
0.9214
5.9678
1.3455
26
0.4884
0.9747
4.1897
1.3999
64
0.3345
0.9786
6.3023
1.4109
27
0.0133
0.0342
4.2030
1.3500
65
0.4179
0.9624
5.8844
1.2849
28
0.1702
0.3694
4.3732
1.3716
66
0.0129
0.0327
5.8973
1.2643
29
0.1904
0.5583
4.5636
1.4188
67
0.4161
0.9041
5.4812
1.1544
30
0.4993
1.4454
5.0629
1.5629
68
0.0336
0.0823
5.5148
1.1437
31
0.2379
0.4698
4.8250
1.4262
69
0.1301
0.3210
5.3846
1.1040
32
0.1755
0.4501
5.0005
1.4518
70
0.5198
1.6047
5.9045
1.2193
33
0.7184
1.8178c
5.7189
1.6102
71
0.6905
1.7878c
6.5950
1.3570
34
0.3091
0.6768
5.4098
1.5271
72
0.0247
0.0547
6.6197
1.3733
35
0.6703
2.1941b
6.0801
1.7128c
73
0.4920
1.4946
7.1116
1.4609
36
0.1362
0.3718
5.9439
1.6863c
74
0.4803
1.2888
7.5919
1.5458
37
0.0412
0.1099
5.9851
1.6805c
75
0.1246
0.2332
7.4673
1.4862
38
0.6036
1.1321
5.3815
1.4869
Note: a, b, c indicate significance at 1%, 5% and 10% levels, respectively.

93
negative. AARs on 3rd and 8th days were at 1.6141 and 1.1706%, respectively, and were
statistically significant at 1% level. AARs on 17th, 35th and 44th days also stood negative at
0.9177, 0.6703 and 0.6997%, respectively and they were significant at 5% level. AARs on
11th, 33rd and 71st trading days (0.7451, 0.7184 and 0.6905%, respectively) were significant
at 10% level.
Among the significant returns, six were in the first half of the event window and the
remaining were in the second half of the event window. The medium-size issue companies
experienced continuous positive returns for seven days from 57th to 63rd trading day. The
number of days with a rate of negative returns was higher than that of the rate of positive
returns, and the price behavior of medium-size issue companies supported overpricing of
IPOs.
The results of CAAR of companies with medium-size issue show that the CAARs for the
first two days were around 2% and were statistically significant at 10% level. The positive
CAAR continued for first seven trading days and became negative from 8th day, and continued
till the last day of the event window.
Out of the 75 trading days, CAARs for 26 days were significant at different levels. After
the first two days, it generated a significant return on 35th trading day, which was a negative
return and was significant at 10% level for three days up to 37th day. Again the CAAR became
significant from 40th day to 60th day of the event window at either 5% or 10% level. CAAR of
40th to 43rd day stood negative with more than 6% and they were significant at 10% level. It
increased further and went to over 7% negative on 44th day (7.0005%), which was significant
at 10% level. CAAR continued with above 7% negative for 11 trading days, of which CAAR
on 45th, 46th and 47th days (7.4480, 7.7430 and 7.6235%) were significant at 5% level.
Other CAARs were significant at 10% level. Due to high and continuous negative returns on
53rd to 56th days, the negative CAAR went down and reached 8% on 55th day. CAARs on 55th
and 56th days stood at 8.4953% and 8.8083%, respectively, which were significant at 5%
level. CAAR on 57th day stayed at 8.3560% and significant at 10% level. CAARs on 58th,
59th and 60th days were significant at 10% level. Because of continuous positive return, the
negative CAAR started decreasing up to 70th trading day.
At the end of the event window, the CAAR of medium-size issue IPOs stood at 7.4673
negative. On the other hand, CAAR of small-size issue companies stood at 14.5630 showing
that CAAR of medium-size issue companies was comparatively less negative than that of the
CAAR of small-size issue companies. Though the results show that the IPOs of medium-size
issue were priced better than the small-size issue, there was overpricing.
Table 3 indicates the AARs of companies with large-size issue. AARs of large-size IPOs
had near 1% negative return on the first day of trading (0.9109), but was not statistically
significant. It means that the market negatively reacted to the large-size issues of the Indian
companies. But on the second trading day, it had a positive return of 0.5538%, and was also
not statistically significant. Only the positive AAR on 10th day (0.8555%) was significant at
10% level. On the 16th trading day, the AAR was 0.8233% and significant at 5% level. AAR
94
on 22nd day was negative at 0.7156% and was significant at 5% level. AARs on 29th and 59th
days were 0.5661 and 0.5110%, respectively, and were significant at 10% level. Large-size
issue companies experienced high and significant negative return on 48th trading day at
0.9093%. On 74th trading day, AAR was negative at 0.9554% and was significant at 5% level.
During the period of event window, only on seven days the AARs were statistically
significant. Out of seven statistically significant returns, four were in the first half of the
event window and the remaining were in the second half. Only on one day more than 1%
negative return was recorded. AARs for 31 days were positive, of which 9 days recorded over
half a percent return and 22 days recorded less than half a percent return. AARs for 44
trading days had negative returns, out of which 8 days had more than half a percent return
and 36 days experienced less than half a percent return.
Table 3: AAR and CAAR of Large-Sized IPOs
Day
AAR%
t-Value
CAAR%
t-Value
Day
AAR%
t-Value
CAAR%
t-Value
0.9109
1.2877
0.9109
1.2877
39
0.4171
0.8795
1.9446
0.6205
0.5538
0.8055
0.3571
0.3495
40
0.0167
0.0366
1.9279
0.5877
0.2872
0.6745
0.6443
0.6353
41
0.6981
1.4786
2.6260
0.7892
0.2493
0.4683
0.8937
0.7973
42
0.1503
0.4613
2.7763
0.8214
0.5829
1.0318
0.3107
0.2326
43
0.0340
0.0845
2.8102
0.8131
0.1002
0.1863
0.4109
0.2649
44
0.0193
0.0328
2.7910
0.8110
0.3604
0.6695
0.7714
0.4559
45
0.0027
0.0059
2.7883
0.7842
0.2657
0.4737
1.0371
0.5124
46
0.4528
1.0340
2.3354
0.6717
0.0548
0.0980
0.9823
0.5167
47
0.4562
1.2088
2.7917
0.7856
10
0.8555
1.6488c
0.1268
0.0632
48
0.9093
2.6713a
3.7010
1.0054
11
0.0306
0.0688
0.1574
0.0844
49
0.2455
0.7829
3.9465
1.0570
12
0.4369
0.8815
0.2795
0.1394
50
0.2891
0.5544
3.6574
0.9405
13
0.5295
1.0371
0.8089
0.4033
51
0.2727
0.5786
3.9300
1.0346
14
0.3081
0.6267
0.5008
0.2231
52
0.0716
0.1648
4.0016
1.0726
15
0.1131
0.2830
0.6139
0.2495
53
0.2659
0.6512
3.7357
0.9780
16
0.8233
2.2545b 0.2094
0.0866
54
0.9019
1.3342
2.8337
0.7033

95
Table 3 (Cont.)
Day
AAR%
t-Value
CAAR%
t-Value
Day
AAR%
t-Value
CAAR%
t-Value
17
0.4133
0.9944
0.6227
0.2606
55
0.4214
1.0197
3.2551
0.8145
18
0.3693
0.9498
0.2534
0.1073
56
0.4543
1.1935
2.8008
0.7166
19
0.4092
0.5484
0.1558
0.0688
57
0.4636
0.8002
3.2644
0.8287
20
0.2184
0.5994
0.0626
0.0288
58
0.3247
0.9392
3.5891
0.9277
21
0.0061
0.0163
0.0687
0.0289
59
0.5110
1.7331c
4.1001
1.0516
22
0.7156
2.2239b 0.7843
0.3180
60
0.4346
0.9496
3.6655
0.9330
23
0.1267
0.2969
0.9110
0.3633
61
0.4448
1.5928
4.1103
1.0706
24
0.3610
1.3237
0.5501
0.2188
62
0.1136
0.1980
3.9967
1.0196
25
0.2416
0.8675
0.7917
0.3087
63
0.1576
0.4247
4.1544
1.0480
26
0.0729
0.1805
0.7188
0.2684
64
0.2204
0.6484
3.9339
0.9800
27
0.1956
0.5480
0.9144
0.3254
65
0.5162
1.2434
3.4177
0.8443
28
0.0480
0.1076
0.9623
0.3371
66
0.4128
1.2275
3.8305
0.9438
29
0.5661
1.7457c
1.5284
0.5138
67
0.9049
1.4319
2.9257
0.7350
30
0.1863
0.6987
1.7147
0.5903
68
0.8603
1.2727
2.0654
0.5318
31
0.2445
0.4005
1.9591
0.6677
69
0.4715
1.2710
2.5369
0.6604
32
0.0071
0.0143
1.9520
0.6939
70
0.0747
0.2081
2.6115
0.6807
33
0.0475
0.0817
1.9995
0.6994
71
0.3651
0.8296
2.2464
0.5985
34
0.0768
0.1267
2.0764
0.6959
72
1.1396
0.8801
3.3860
0.8748
35
0.1869
0.5184
1.8895
0.6031
73
0.3033
0.6523
3.0827
0.7921
36
0.6089
1.4853
1.2807
0.4076
74
0.9544
2.4136b
4.0371
1.0345
37
0.1271
0.3165
1.1535
0.3661
75
0.2759
0.5088
4.3130
1.0960
38
0.3740
0.9458
1.5275
0.4827
Note:
96
a, b, c
indicate significance at 1%, 5% and 10% levels, respectively.
The first day return was negative (0.9109%) for large-size issue companies. The companies
with small-size and medium-size issues generated positive returns on the first day of trading
(1.0234 and 1.9069%, respectively), of which only the returns of medium-size issue companies
were statistically significant. Though the companies with large-size issue had negative returns
on the first day, on the next day they turned positive and the rate of positive returns was
comparatively high. The first day negative return indicated that the market reacted negatively
on the large-size issues of the Indian IPOs.
The results of CAARs of companies with large-size IPOs show that the CAAR started
with negative return on the first day, and the negative return continued till 7th day of trading
with less than 1%. Due to high negative returns, it went to more than 1% negative on the 8th
day. High positive AAR was reported on the 10th day of trading at 0.8555% and hence CAAR
had an improvement, and again declined to less than 1% negative on that day, and the trend
continued till the 11th trading day.
The companies with large-size issue experienced high positive returns on 10th, 12th and
13 trading days. Due to this, CAAR increased and became positive on the 12th trading day.
The positive trend was present only for four trading days. Due to a high negative return on
the 16th day (0.8233%), CAAR became negative and continued for three more days. On the
19th trading day, CAAR was positive at 0.1558%, but from 20th trading day it became negative
and continued with negative CAAR till the last day of the event window.
th
From 20th to 28th day, the CAAR was negative with less than 1%. On 29th day, CAAR
reached more than 1% negative and was over 2% due to continuous negative returns in
subsequent days. From the 35th trading day onwards, it had positive AAR for three days. The
CAAR had an improvement and went to less than 2% and the same trend was continued till
the 40th trading day. There was a high negative AAR on 41st day (0.6981%) and due to this,
CAAR became 2.6260% on 41st day and was more than 2% negative up to 47th trading day.
CAAR of large-size issue companies reached 3% negative on 48th trading day (3.7010%),
and gradually increased to 4% negative on 52nd trading day (4.0016%). Due to high positive
AARs on 53rd, 54th and 56th trading days at 0.2659%, 0.9019% and 0.4543%, respectively, it
went to 3% again on the 53rd trading day and on the next day it went below 3%. Though
CAAR stood between 3% and 4% from 57th to 66th trading days, with high positive returns on
67th and 68th trading days (0.9046 and 0.8603%), it declined to 3% on 67th day and the trend
followed up to 71st day. CAAR stood at 4.3130% on the last day of the event window.
Comparing CAAR of small-size issues and medium-size issues, which stood at 14.5630
and 7.4673%, respectively, the CAAR of companies with large-size issues at the end of the
event window was lower at 4.313. It indicates that when the size of issue increases, Indian
companies price their IPOs better. In other words, IPOs of companies involving large-size
issue price performance was better than small-size and medium-size issue companies.
CAARs of IPOs on the basis of the size of issue show a higher rate of declining trend in
small-size issue, indicating heavy overpricing of these set of companies. CAARs of mediumsize IPOs also show a declining trend in the returns during the event window, but at a less rate
of fall during the end of the event window. CAARs of large-size IPO issue of the Indian
97
companies though declining, is at a much lesser rate as well as value compared to the other
issue sizes.
The above analysis based on the size brings out that small-size issues have been less
efficiently priced, followed by medium-size issues. These two together resulted in bringing
down the average, downplaying the more reasonable pricing of large-size issues.
Figure 1 exhibits the flow of CAAR of Indian IPOs on the basis of their size. It shows that
large-sized IPOs were priced better than small and medium-sized IPOs.
Figure 1: CAAR of IPOs on the Basis of Size of Issue
5
Large-Sized
IPOs
CAAR%
0
5
10
Medium-Sized IPOs
15
20
Small-Sized IPOs
Days
Conclusion
The study has made an attempt to analyze the IPO performance of the Indian companies on
the basis of size of IPOs for a period of 10 years from 2001 to 2010. It was observed that the
market reacted positively towards small and medium-size IPOs, with AARs on the first day
of trading being 1.42% and 1.83%, respectively. The market reacted negatively towards largesize IPOs, with a negative AAR of 0.91% on the first day of trading. The study found that
Indian IPOs underperformed during the study period irrespective of their size. The study also
found that when the size of IPOs increases, the performance was better. The CAAR on the
last day of the event window of small-size IPOs stood at 14.56% and the CAAR of mediumsize IPOs stood at 7.47%. The CAAR of large-size IPOs on the last day of event window
stood at 4.51%. It showed that CAAR decreases when the size of IPOs increases. Therefore,
it is concluded that large-sized IPOs were priced better.
References
1.
98
Chopra R I (2009), Price Performance of IPOs in Indian Stock Market, Unpublished

M.Phil. Dissertation, School of Management and Social Sciences, Thapar University,
Punjab.
2.
Eswaran R (2009), Analysis of Post-Listing Price Movements of Selected Company

Shares, Indian Journal of Finance, Vol. 3, No. 5, pp. 24-30, 38.
3.
Henderson G V (1990), Problems and Solutions in Conducting Event Studies, The

Journal of Risk and Insurance, Vol. 57, No. 2, pp. 282-306.
4.
Islam M A, Ali R and Ahmad Z (2010), An Empirical Investigation of the Underpricing

of Initial Public Offerings in the Chittagong Stock Exchange, International Journal of
Economics and Finance, Vol. 2, No. 4, pp. 36-46.
5.
Jagadeesh N, Weinstein M and Welch I (1993), An Empirical Investigation of IPO

Returns and Subsequent Equity Offerings, Journal of Financial Economics, Vol. 34,
No. 2, pp. 153-175.
6.
Jaitly S (2004), Pricing of IPOs and Their After Issue Performance in the Indian
Equity Market, Managerial Finance, Vol. 30, No. 1, pp. 29-45.
7.
Mugugesu J and Santhappraj A S (2009), Valuation Errors and the Initial Price Efficiency
of the Malaysian IPO Market, The IUP Journal of Applied Finance, Vol. 15, No. 10,
pp. 19-38.
8.
Page M J and Reyneke I (1997), The Timing and Subsequent Performance of Initial
Public Offerings (IPOs) on the Johannesburg Stock Exchange, Journal of Business
Finance and Accounting, Vol. 24, Nos. 9 and 10, pp. 1401-1420.
9.
Sohail M K and Nair M (2007), Performance of Initial Public Offerings in Pakistan,

International Review of Business Research Papers, Vol. 3, No. 2, pp. 420-441.
10.
Zhou Z and Zhou J (2010), Chinese IPO Activity, Pricing, and Market Cycles, Review
of Quantitative Finance and Accounting, Vol. 34, No. 4, pp. 483-503.
Reference # 01J-2013-10-06-01

99
Information to Authors
The paper should be typed in MS Word.
Title of the paper should be followed by name, e-mail and affiliation of author(s).
The paper should be accompanied with a declaration to the effect that the paper is the
original work of the author(s) and that the paper has not been submitted for publication
anywhere else.
In case of papers presented/submitted in a conference/seminar, details must be clearly

mentioned, and the author should specify with whom the copyright rests.
Use a single column layout with both left and right margins justified.
Font: Main Body12 pt.; Style: Times, or the closest comparable font available.
Tables and Figures

To the extent possible, tables and figures should appear in the document near/after where
they are referred in the text. Avoid the use of overly small type in tables. In no case should
tables or figures be in a separate document or file.
An abstract of not more than 200 words is required.
The paper should start with an introduction and end with a conclusion summarizing the
findings of the paper.
References
It is the authors obligation to provide complete references with the necessary information.
References should appear in the text as: Sharpe (1992) reported that ... and the list of
all the references must be placed at the end of the manuscript in the following style:
Sharpe F (1992), Asset Allocation: Management Style and Performance Measurement,
Journal of Portfolio Management, Vol. 18, No. 2, pp. 7-19.
Shaw E S (1973), Financial Deepening in Economic Development, Oxford University
Press, New York.
Papers are processed through a blind referral system by experts in the subject areas. To
ensure anonymity, the writers name, designation and other details should appear only on
the first page along with the title of the paper and should not be repeated anywhere else.
All manuscripts should be in electronic form and sent to:

The Editor
The IUP Journal of Applied Finance
IUP Publications
Tel: +91(40)23430448
E-mail: info@iupindia.in; ijappfin@iupindia.in
Website: www.iupindia.in
The Effect of Quarterly Earnings Announcements on Sensex: A Case with Clustering of Events
95

Applied Finance

Enviado por

Dados do documento

Descrição original:

Direitos autorais

Formatos disponíveis

Compartilhar este documento

Compartilhar ou incorporar documento

Opções de compartilhamento

Você considera este documento útil?

Este conteúdo é inapropriado?

Direitos autorais:

Formatos disponíveis

Applied Finance

Enviado por

Direitos autorais:

Formatos disponíveis

Vol.

Dynamic Relationship Between Futures Trading

Factors Influencing Abnormal Returns Around

Did the Great East Japan Earthquake Have an Impact

Forecasting Daily Stock Volatility Using GARCH Model:

The Performance of Initial Public Offerings Based on Their Size:

The IUP Journal of Applied Finance is published four

IJAF is a registered trademark.

No part of this publication may be reproduced or

IUP holds the copyright to all articles

The views expressed in this publication are purely

All efforts are made to ensure that the published

Send your feedback to

Payment to be made by crossed Demand Draft drawn

Dynamic Relationship Between Futures Trading

The IUP Journal of Applied Finance, Vol. 19, No. 4, 2013

The IUP Journal of Applied Finance, Vol. 19, No. 4, 2013

The test statistic for this hypothesis is

y1t, y2t 11' ,i ,12' ,i | 21' ,i , 22' ,i y1,t i, y2,t i CD t u1t , u 2t

This can be written as

kj2 , n ... kj2 ,h 1

The IUP Journal of Applied Finance, Vol. 19, No. 4, 2013

To calculate forecast error variance decompositions as percentage terms,

Table 2: Coefficients of GARCH(1,1) Model used to Estimate Futures Price

The IUP Journal of Applied Finance, Vol. 19, No. 4, 2013

Note: SV = Spot Volatility, TV = Unexpected Trading Volume, OI = Unexpected Open Interest, FV =

Note: The p-values in bold numeric are statistically significant at 5% level.

The IUP Journal of Applied Finance, Vol. 19, No. 4, 2013

Note: The p-values in bold numeric are statistically significant at 5% level.

Table 8: 21 days Forecast Error Variance Decomposition

The IUP Journal of Applied Finance, Vol. 19, No. 4, 2013

2. Asche F and Guttormsen A G (2002), Lead-Lag Relationship Between Futures and

The IUP Journal of Applied Finance, Vol. 19, No. 4, 2013

Shocks and Herding Contagion

The IUP Journal of Applied Finance, Vol. 19, No. 4, 2013

The Trivariate BEKK-GARCH Model

The IUP Journal of Applied Finance, Vol. 19, No. 4, 2013

h 11,t 11 11 12,t 1 2 12 1,t 1 2,t 1 2 31 1,t 1 3,t 1

11 11h11,t 1 212h12,t 1 2 31h13,t 1

Shocks and Herding Contagion in the Oil and Stock Markets

h 22,t 12 12 12,t 1 2 22 1,t 1 2,t 1 2 32 1,t 1 3,t 1

12 12 h11,t 1 2 22 h12,t 1 2 32 h13,t 1

h 33,t 13 13 12,t 1 2 23 1,t 1 2,t 1 2 33 1,t 1 3,t 1

13 13h11,t 1 2 23h12,t 1 2 33h13,t 1

Time-Varying Parameter Model

The IUP Journal of Applied Finance, Vol. 19, No. 4, 2013

and the state transition operator which is applied to pervious state t 1.

and the conditional variance of the prediction error is calculated as:

where pt is the index price in month t.

Results and Discussion

The IUP Journal of Applied Finance, Vol. 19, No. 4, 2013

Table 1: Results of the Trivariate GARCH Model

Shocks and Herding Contagion in the Oil and Stock Markets

Panel B: Oil Importing Countries

The IUP Journal of Applied Finance, Vol. 19, No. 4, 2013

Panel B: Oil Importing Countries (Cont.)

Shocks and Herding Contagion in the Oil and Stock Markets

0.7755* 0.1528*** 0.114**

Herding Contagion Between Oil Market and Stock Markets

The IUP Journal of Applied Finance, Vol. 19, No. 4, 2013

Table 2: Descriptive Statistics

Argentina Malaysia Denmark

Panel B: Oil Importing Countries

0.7755* 0.1528* 0.114

6.348 () 5.510 ()