Effects of Changes in Index Composition on Stock Market: Evidence from the Istanbul Stock Exchange
65 Pages Posted: 15 Jun 2001
Date Written: undated
Previous evidence of US stock markets has shown that stocks included in (excluded from) index exhibit significant positive (negative) abnormal returns on the announcement day and trading volume is effected by the event. However the existing literature has not provided a unique explanation of the results. This is the first study that examines the price and volume effects on stocks associated with the changes in value-weighted index composition of two separate indices, ISE-100 and ISE-30, of the leading emerging market - Istanbul Stock Exchange in the period between years 1995 and 2000 and also in several sub-periods. 204 additions and 180 deletions in 24 quarterly periodical index revision intervals are analyzed by using event-study and standardized cross-sectional test methodology shown by Boehmer, Musumeci and Poulsen (1991).
Consistent to previous evidence of US stock markets, we find that stocks included in (excluded from) index, particularly for the ISE-30, tend to generate positive (negative) abnormal returns in the event period until effective change date and trading volume is effected by the event significantly. Price decreases after the change date both for included and excluded stocks. Behavior of stock prices has interesting patterns around the index revision period, however the statistical and economical significance of the cumulative abnormal returns are weak due to lack and weakness of index funds, institutional investors, mutual funds invest in stocks and non-existing of derivatives trading. Therefore, both the price pressure and imperfect substitutes hypotheses are unlikely explanations for the findings for ISE, consistent to the results of Beneish and Whaley (1995).
The effects of changes in index composition on stock market have been explored not only by cumulative abnormal returns but more strongly by the volume ratios. Abnormal volume behavior exists both for added and excluded stocks which are greater than one and strongly significant. There is significant increase in abnormal volume after announcement and on change date for excluded stocks, whereas it falls after effective change date. Volume variability of the added-deleted stocks indicates a significant increase after the announcement and then hits to the highest level on the effective change day. This evidence confirms our previous findings that market reacts to changes in index composition, particularly for the stocks subject to deletion from index. One factor in explaining this behavior might be the regulation of the ISE that requires only the stocks in ISE-100 can be subject to margin trading, lending and borrowing and also to short selling which causes the closing of margin trading accounts on deleted stocks after the deletion is effective on change date and also rejecting of those stocks as collateral by brokerage houses.
Decreasing price and volume for excluded stocks after announcement is also consistent with the information cost and liquidity explanation. Additionally, long-run abnormal volume in event period can not be attributed to the use of index stocks in arbitrage with derivative instruments as Lynch and Mendenhall (1997) did, since there is no derivatives trading in Turkish capital markets yet. Abnormal trading on or just prior to announcement day may partly be attributed to speculative trading based on the estimations of the possible included-excluded stocks that are spreaded out by rumors. This is consistent to our expectation that the revisions can be estimated by the traders since the criteria and the data used for index revisions are publicly available like Italian Stock Market shown by Rigamonti and Barontini (2000) recently.
Finally, all evidence show that changes in index composition does matter for the market participants and have impact on return and volume of stocks added to and particularly deleted from the index in Istanbul Stock Exchange. One implication for future research is that we expect that the effects of changes in index composition on stock market will be clear and stronger both statistically and economically in ISE in the future by the growth of index funds, institutional investors, mutual funds invest in stocks and also by existing of the derivatives trading in Turkish capital markets.
Keywords: Stock index revisions, Index composition, Price and Volume effects
JEL Classification: G12, G14
Suggested Citation: Suggested Citation