Chapter 13 Stock Markets
Hung Wan Kot
University of Macau
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FINC3003 Chapter 13
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FINC3003
Financial Markets
Financial Institutions
Money Market
Mutual Fund Ind
Bond Market
Insurance Companies
Stock Market
Investment Banks
Mortgage Market
Venture Capital Firms
Commercial Banks
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Chapter Outline







Investing in Stocks
Computing the Price of Common Stock
How the Market Sets Security Prices
Errors in Valuation
Stock Market Index
ADRs
Long-term performance of index revisions
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Investing in Stocks

Represents ownership in a firm

Earn a return in two ways
 Price of the stock rises over time
 Dividends are paid to the stockholder

Stockholders have claim on all assets

Right to vote for directors and on certain issues

Two types
 Common stock: Right to vote | Receive dividends
 Preferred stock: Receive a fixed dividend | Do not usually vote
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Sample Stock Certificate: Sapir Consolidated Airlines
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Investing in Stocks: How Stocks are Sold

Organized exchanges
─
─
─
─
NYSE is best known, began trading in 1792. 24 brokers began trading a few stocks on
Wall Street.
“Organized” used to imply a specific trading location. But computer systems (ECNs)
have replaced this idea.
Others include the ASE (US), and Nikkei, LSE, DAX (international)
Listing requirements exclude small firms
NYSE merged
Archipelago
2006
7
NYSE combined Euronext to
NYSE Euronext
2007
NYSE Euronext
acquired Amex
2009
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Intercontinental Ex
purchased NYSE Euronext
2013
H.W. Kot
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Circuit-breaker in U.S.
https://news.cgtn.com/news/2020-03-28/What-are-stock-market-circuit-breakers-and-how-do-they-work--Pd2lBRmfza/index.html
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March 2020
Warren Buffett said that he
lived for 89 years old also have
not seen this scene when
March 8, the fist “circuit
breaker” happens.
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Investing in Stocks: How Stocks are Sold

Over-the-counter markets
─
─
─
─
12
Best example is NASDAQ
Dealers stand ready to make a market
Today, about 3,000 different securities are listed on NASDAQ.
Important market for thinly-traded securities—securities that don’t trade very often.
Without a dealer ready to make a market, the equity would be difficult to trade.
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Investing in Stocks: Organized vs. OTC

Organized exchanges (e.g., NYSE)
─
─
─

Auction markets with floor specialists
25% of trades are filled directly by specialist
Remaining trades are filled through SuperDOT
Over-the-counter markets (e.g., NASDAQ)
─
─
─
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National Association of Securities Dealers Automated Quotation System
Multiple market makers set bid and ask prices
Multiple dealers for any given security
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Investing in Stocks: ATSs and MTFs




Alternative trading systems (ATSs)
Multilateral trading facilities (MTFs)
ATSs and MTFs consist of Electronic Communications Networks (ECNs)
ECNs allow brokers and traders to trade without the need of the middleman.
They provide:
•
•
•
•
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Transparency: everyone can see unfilled orders
Cost reduction: smaller spreads
Faster execution
After-hours trading
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Investing in Stocks: ECNs
However, ECNs are not without their drawbacks:
 Don’t work as well with thinly-traded stocks
 Many ECNs competing for volume, which can be confusing
 Major exchanges are fighting ECNs, with an uncertain outcome
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Trading
Exchanges
•
•
•
•
•
•
16
NYSE
NASDAQ
LSE
HKEx
SHSE
…
ATSs & MTFs
• Dark pools (黑池)
• ECNs
• …
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Dark Pool




A dark pool is a private financial forum or exchange for trading securities. dark pools
are not accessible by the investing public.
Non-exchange trading accounting for about 40% of all U.S. stock trades in 2014 (15%
from Dark pools).
They are mostly used by institutional investors for block trades involving a large
number of securities.
As of Feb 2020, there were >50 dark pools in the U.S.
Dark pools explained
https://www.youtube.com/watch?v=hq9waP7goSc
http://www.investopedia.com/articles/markets/050614/introduction-dark-pools.asp
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Types of Dark Pools

Broker-dealer owned: These dark pools are set up by large broker-dealers for their
clients.


Agency broker or exchange-owned: These are dark pools that act as agents, not as
principals. As prices are derived from exchanges


Examples Goldman Sachs’ Sigma X, Citi’s Citi Match and Citi Cross, and Morgan Stanley’s MS Pool.
Examples of agency broker dark pools include Instinet,, while exchange-owned dark pools include
NYSE Euronext.
Electronic market makers: These are dark pools offered by independent operators
like Getco and Knight.
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Dark Pools: Pros and Cons



Reduced market impact/Avoidance of
price devaluation
Lower transaction costs
Private trading




HSBC: StockMax
in 2013
19
Exchange prices may not reflect the
real market
Pool participatns may not get the best
price
Vulnerability to predatory trading by
HFTs
Small average trade size reduces need
for dark pools (averaged 187 shares per
trade)
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ECNs vs Dark Pool




ECNs are a type of ATS that trade listed stocks and other exchange-traded products.
Unlike dark pools, another type of ATS, ECNs display order in the consolidated
quote stream.
As ATSs, ECNs are required to register with the Commission as broker-dealers and
are also members of FINRA.
Examples of ECNs: Instinet, SelectNet, and NYSE Arca.
https://www.sec.gov/answers/ecn.htm
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orders
orders
Exchanges
ECN (BATS)
Dark Pools
order
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ECNs vs Dark Pool



To place orders directly with an ECN, a person must be an ECN subscribers.
Typically, only broker-dealers and certain institutional traders are permitted to
become ECN subscribers.
Individual investors must have an account with a broker-dealer subscriber to place an
order on an ECN.
https://www.sec.gov/answers/ecn.htm
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ATSs vs Exchanges



Although both exchanges and ATSs provide marketplaces for buyers and sellers to
transact in securities, ATSs do not necessarily provide public information on the best
prices available to traders within their system.
They also do not set rules governing the conduct of subscribers and they perform
no self-regulation, while exchanges perform all of these functions.
Additionally, because ATSs are regulated as broker-dealers, they comply with a
different set of regulations than traditional exchanges.
https://www.sec.gov/marketstructure/research/alternative-trading-systems-march-2014.pdf
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New Trading Strategies: Algorithmic Trading and HighFrequency Trading
https://tradingsim.com/blog/how-has-algorithmic-trading-impacted-the-futures-markets/
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https://tradingsim.com/blog/how-has-algorithmic-trading-impacted-the-futures-markets/
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Chapter Outline







Investing in Stocks
Computing the Price of Common Stock
How the Market Sets Security Prices
Errors in Valuation
Stock Market Index
ADRs
Long-term performance of index revisions
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Computing the Price of Common Stock

Valuing common stock is, in theory, no different from valuing debt securities:
─
─

determine the cash flows
discount them to the present
We will review four different methods for valuing stock, each with its
advantages and drawbacks.
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Computing the Price of Common Stock: The One-Period
Valuation Model

Simplest model, just taking using the expected dividend and price over the
next year.

What is the price for a stock with an expected dividend and price next year
of $0.16 and $60, respectively? Use a 12% discount rate.
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Computing the Price of Common Stock: The Generalized
Dividend Valuation Model

Most general model, but the infinite sum may not converge.

Rather than worry about computational problems, we use a simpler version,
known as the Gordon growth model.
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Estimating Dividends: Special Cases

Constant dividend




Constant dividend growth


The firm will increase the dividend by a constant percent every
period
Supernormal growth

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The firm will pay a constant dividend forever
This is like preferred stock
The price is computed using the perpetuity formula
Dividend growth is not consistent initially, but settles down to
constant growth eventually
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16000
Profit
14000
12000
Revenue
10000
8000
6000
4000
Dividend
2000
0
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
http://www.mtr.com.hk/chi/investrelation/financialinfo.php
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Average
Dividend growth
3% (2001-2007)
Billion
700
Growth
60%
Revenue
600
50%
Profit
40%
500
30%
400
20%
300
Revenue
10%
Profit
Revenue growth
Profit growth
2001-2008
22%
22%
2009-2014
6%
0%
http://www.chinamobileltd.com/?lang=en
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2014
2013
2011
2011
2010
2009
2008
2002
2007
-20%
2006
0
2005
-10%
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
100
2004
0%
2003
200
Generalized formula
D1 + P1
D1
D2
P2
=
+
+
(1 + r ) (1 + r ) (1 + r ) 2 (1 + r ) 2
D3
P3
D1
D2
=
+
+
+
(1 + r ) (1 + r ) 2 (1 + r ) 3 (1 + r ) 3
D3
D1
D2
D4
DT
PT
=
+
+
+
+
...
+
+
(1 + r ) (1 + r ) 2 (1 + r ) 3 (1 + r ) 4
(1 + r )T (1 + r )T
Po =
T
=
t =1
Dt
PT
+
(1 + r ) t (1 + r )T
If T →∞

Dt
Po = 
t
(
1
+
r
)
t =1
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No matter how high the stock price is
in the very distant future, its present
value is essentially zero
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Remarks




P0 is the ex-dividend price of the stock
 The stock price immediately after paying the current dividend! (This is also true
for any Pt)
The stock price does not depends on how long an investor is going to keep the
stock.
We implicitly assume that corporations will not go bankrupt in the future.
Why are shares of stock in companies that currently pay no dividends traded at
positive prices? For example, Alibaba and firms with loss.
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Currently Pays No Dividends

The market value derives from
 The hope of future dividends
 Price won’t continue to increase forever. The company will eventually run
out of productive ways to use its cash.
 E.g., Microsoft in 2003, Apple in 2012
 Berkshire Hathaway?
 The expectation of a liquidating dividend
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Constant Growth

Assume that dividends will grow at a constant rate, g, forever
D1 = D 0 (1 + g )
D 2 = D1 (1 + g ) = D 0 (1 + g ) 2
D 3 = D 2 (1 + g ) = D 0 (1 + g ) 3
D t = D t −1 (1 + g ) = D t − 2 (1 + g ) 2 = ... = D0 (1 + g ) t

P0 =
 (1 + r)
t =1
P0 =
37

Dt
t
=

t =1
Do (1 + g )
D1 (1 + g ) t −1
D1
…
=
=
.
t
(r - g)
(r - g)
(1 + r )
D1
r−g
FINC3003 Chapter 13
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Computing the Price of Common Stock: The Gordon
Growth Model

Same as the previous model, but it assumes that dividend grow at a constant
rate, g. That is,
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Computing the Price of Common Stock: The Gordon
Growth Model
The model is useful, with the following assumptions:
 Dividends do, indeed, grow at a constant rate forever
 The growth rate of dividends, g, is less than the required return on the equity,
ke.
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Remarks

How can g ever be assumed to be constant?
 lies in the competitive equilibrium.
 Firms will often attempt to manage their dividend policy so
that there is a reasonably constant growth in dividends.
Motor industry in US
九龍塘火車站收舊報紙
美國汽車品牌
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Remarks

How can we assume that r > g ?
 In short-run, g maybe greater than r.
 In equilibrium, high returns on investment will attract capital, which will ensure that
in the succeeding periods, higher returns cannot be earned without taking greater
risk.
 But taking greater risk will increase r, so g can not be increased without raising r.
中國房地產
APPLE
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Computing the Price of Common Stock: The Generalized
Dividend Valuation Model

The price earnings ratio (PE) is a widely watched measure of much the market
is willing to pay for $1.00 of earnings from the firms.
If the industry PE ratio for a firm is 16, what is the current stock price for a
firm with earnings for $1.13 / share?
Answer:
Price = 16  $1.13 = $18.08

More on P/E ratio https://www.youtube.com/watch?v=_NAZxlIaf8U
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P/E trap
Current stock price
Earnings per share
Low P/E ratio is from:
• Low current price => high future price
• High current earnings => Low future
earnings
Tip: stocks paying stable (high) dividends
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Chapter Outline







Investing in Stocks
Computing the Price of Common Stock
How the Market Sets Security Prices
Errors in Valuation
Stock Market Index
ADRs
Long-term performance of index revisions
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How the Market Sets Security Prices





Generally speaking, prices are set in competitive markets as the price set by
the buyer willing to pay the most for an item.
The buyer willing to pay the most for an asset is usually the buyer who can
make the best use of the asset.
Superior information can play an important role.
Short-term: Demand & Supply
Long-term: Fundamental
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How the Market Sets Security Prices

Consider the following three valuations for a stock with certain dividends but
different perceived risk:

Bud, who perceives the lowest risk, is willing to pay the most and will
determine the “market” price.
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Errors in Valuation
Although the pricing models are useful, market participants frequently
encounter problems in using them. Any of these can have a significant impact
on price in the Gordon model P=D/(r-g).
• Problems with Estimating Growth
• Problems with Estimating Risk
• Problems with Forecasting Dividends
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Errors in Valuation: Dividend growth rates
Table 13.1 Stock Prices for a Security with D0 = $2.00, ke = 15%, and
Constant Growth Rates as Listed
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Errors in Valuation: Required returns
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Errors in Valuation
Security valuation is not an exact science!
Considering different growth rates, required rates, etc., is important in
determining if a stock is a good value as an investment.
在市場轉捩點附近，大多數人的感覺
永遠是錯誤的。
DJIA
如果你是瑞士口音，人们将会把你的
智商高估50分；如果是牛津剑桥口音，
可被高看25分；而可怜的老美，在这
里是入不了品的。
——對沖基金風雲錄
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Case: The 2007–2009 Financial Crisis and the Stock Market

The financial crisis, which started in August 2007, was the start of one of
the worst bear markets.

The crisis lowered “g” in the Gordon Growth model - driving down prices.

Also impacts ke - higher uncertainty increases this value, again lowering
prices.

The expectations were still optimistic at the start of the crisis. But, as the
reality of the severity of the crisis was understood, prices plummeted.
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Case: 9/11, Enron and the Market

Both 9/11 and the Enron scandal were events in 2001.

Both should lower “g” in the Gordon Growth model - driving down prices.

Also impacts ke - higher uncertainty increases this value, again lowering
prices.

We did observe in both cases that prices in the market fell. And
subsequently rebounded as confidence in US markets returned.
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Chapter Outline







Investing in Stocks
Computing the Price of Common Stock
How the Market Sets Security Prices
Errors in Valuation
Stock Market Index
ADRs
Long-term performance of index revisions
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Stock Market Indexes


Stock market indexes are frequently used to monitor the behavior of a groups
of stocks.
Major indexes include the Dow Jones Industrial Average, the S&P 500, and the
NASDAQ composite.
https://www.youtube.com/watch?v=f0vdMBsC6fM
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The Thirty Companies That Make Up the Dow Jones
Industrial Average
3M, American Express, Amgen, Apple, Boeing, Caterpillar, Chevron, Cisco
Systems, Coca-Cola, Disney, Dow, Goldman Sachs, Home Depot,
Honeywell, IBM, Intel, Johnson & Johnson, JP Morgan Chase, McDonald’s,
Merck, Microsoft, Nike, Procter & Gamble, Salesforce, Travelers,
UnitedHealth,Visa, Walgreens, and Walmart.
The highest close for the DJIA since 1896 (when it was first introduced) is
36,799.65 on January 4, 2022.
http://money.cnn.com/data/dow30/
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Stock Market Indexes

$1.00 invested in the DJIA back in 1980 (DJIA was around 800) would have
grown to about $16.40 in 2012 (Dow closed year at 13,104). This represented
an annual growth rate around 8.8%.

What’s annual growth rate if Down closed in year 2022 at 33147?
800*[(1+g)^43]=33147
G=9.05%


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Buying Foreign Stocks


Buying foreign stocks is useful from a diversification perspective. However, the
purchase may be complicated if the shares are not traded in the U.S or your
home country.
American depository receipts (ADRs) allow foreign firms to trade on U.S.
exchanges, facilitating their purchase. U.S. banks buy foreign shares and issue
receipts against the shares in U.S. markets.
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Designing a Strategy to Source Equity Globally (refer to Citibank ADR
guide)

Depositary receipts (depositary shares) are negotiable certificates issued by a
bank to represent the underlying shares of stock, which are held in trust at a
foreign custodian bank.

American depository receipts (ADRs) are certificates traded in the United States
and denominated in US dollars.

ADRs are sold, registered, and transferred in the US in the same manner as
any share of stock with each ADR representing some multiple of the
underlying foreign share. (China Mobile, 1 ADR=5 shares)
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Mechanics of American Depositary Receipts (ADRs)
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Designing a Strategy to Source Equity Globally

ADRs can be exchanged for the underlying foreign shares, or vice versa, so
arbitrage keeps foreign and US prices of any given share the same after
adjusting for transfer costs.

While ADRs are quoted only in US dollars and traded only in the US, Global
Registered Shares (GRSs) can be traded on equity exchanges around the globe
in a variety of currencies.

May not list on home market, like Baidu, Alibaba.
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China Mobile
listed on HKEx
and NYSE
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China Mobile listed on HKEx and Shanghai A-share market
March 22, 2022
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Panel A: Pure domestic listing
1800
1600
1400
1200
1000
800
600
400
200
Developed
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
0
Emerging
Hung Wan Kot, Liang Shao and Lewis Tam, 2021, Cross-listing and reverse cross-listing: Role of national culture.
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Panel B: Cross-listings
250
200
150
100
50
Developed
Emerging
Hung Wan Kot, Liang Shao and Lewis Tam, 2021, Cross-listing and reverse cross-listing: Role of national culture.
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2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
0
Panel A: Proceeds from local portion and global portion
300000
250000
Million USD
200000
150000
100000
50000
Local Proceeds
Global Proceeds
Hung Wan Kot, Liang Shao and Lewis Tam, 2021, Cross-listing and reverse cross-listing: Role of national culture.
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2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
0
120,000
60%
100,000
50%
80,000
40%
60,000
30%
40,000
20%
20,000
10%
Total Proceeds from Cross-listing IPOs
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
0%
1990
-
Proceeds of cross-listing/Total porceeds
Hung Wan Kot, Liang Shao and Lewis Tam, 2021, Cross-listing and reverse cross-listing: Role of national culture.
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Croll-listing/Total proceeds
Million USD
Panel B: Cross-listing IPOs
Benefits for a DR program for issuers








Access capital outside the issuer’s home market
Build company visibility in the U.S. and internationally
Broaden and diversify shareholder base
Expand opportunity to increase local share price as a result of global
demand/trading
Enlarge the market for the company’s shares, potentially increasing liquidity
Adjust share price levels to those of peers through DR ratio
Facilitate merger and acquisition activity through use as acquisition currency
Develop stock option plans and stock purchases plans for U.S. employees
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Benefits of a DR program for investors







Facilitating diversification into Non-U.S. securities
Trading, clearing and settling in accordance with practices of the investor’s
home market
Eliminating cross border custody safekeeping charges
Providing enhanced accessibility of research, and of price and trading
information
Allowing easy comparison to securities of similar companies trading in the
investor’s home market
Permitting dividend payments in US$ and corporate action notifications in
English
Allowing for lower dividend tax rates for exchanged-listed ADRs
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My related articles in the HK newspapers
明報
• 5國企退美市 不足為奇（2022.8.17）
• 中概股回港上市高股價之謎（2021.6.18）
• 跨境上市 貴在「承諾」——中國三大電訊商被
美退市的啟示（2021.1.13）
香港經濟日報
• 中資股來港第二上市續增 有何啟示（2020.9.14）
• 阿里回港上市 衣錦還鄉抑另有所求？
（2019.11.20）
• 澳交所倘成立 吸4類企業跨境上市（2019.11.7）
• 阿里巴巴不來 港人焉知非福（2013.12.24）
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Regulation of the Stock Market


The primary mission of the SEC of HK is “…to protect investors and maintain
the integrity of the securities markets.”
The SEC brings around 500 actions against individuals and firms each year
toward this effort. This is accomplished through the joint efforts of four
divisions.
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Regulation of the Stock Market: Divisions of the SEC
Division
Duty
Corporate
Finance
responsible for collecting, reviewing, and making available all of
the documents corporations and individuals are required to file
Market Regulation establishes and maintains rules for orderly and efficient markets
Investment
Management
Enforcement
75
oversees and regulates the investment management industry
investigates violations of the rules and regulations established by
the other divisions
FINC3003 Chapter 13
H.W. Kot
https://podcast.rthk.hk/podcast/item.php?pid=911&lang=zh-CN
76
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Chapter Outline







Investing in Stocks
Computing the Price of Common Stock
How the Market Sets Security Prices
Errors in Valuation
Stock Market Index
ADRs
Long-term performance of index revisions
77
S&P 500 Index
Hang Seng Index
CSI 300 Index
FINC3003 Chapter 13
H.W. Kot
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A comprehensive long term analysis of S&P 500
Index additions and deletions
Kalok Chan, Hung Wan Kot, & Gordon Y.N. Tang
Journal of Banking & Finance, 2013 (37), 2920-2930
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FINC3003 Chapter 13
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
1970
1968
1966
1964
1962
Number of Constituent Stock Changes
70
60
50
40
30
20
10
0
H.W. Kot
Motivations



Lack of study on long-run performance after stocks added to or deleted from an
index.
Changes of an index constituent stocks is an important event.
The fraction of index funds among mutual funds increased significantly.
81
WSJ 2012.2.20
2001
2011
Index fund
ETF
Asset(100 million US$)
278
119
3,470
336
1148
12,400
Index fund/Stock fund (asset)
16%
33%
FINC3003 Chapter 13
H.W. Kot
Questions


What’s the long-run stock performance of addition stocks and deletion stocks?
What are the driving forces?
 Long-run operating performance
 Information environment
 Institutional ownership
 Analyst coverage, dispersion of forecasts
 Liquidity
 Investor awareness/shadow costs
 Insider trading
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Market Adjusted Buy-and-hold Returns (Table 2)
Post Event Months
83
[0, 36]
[1, 36]
[1, 60]
Raw returns (additions)
0.44
0.40
0.75
Raw (additions) - CRSP
0.09**
0.06
0.11**
T-value
2.22
1.59
2.17
Raw returns (deletions)
0.61
0.68
1.07
Raw (deletions) - CRSP
0.32***
0.41***
0.54***
T-value
3.83
4.40
4.92
Raw Ret (Deletions) – Raw Ret (Additions)
0.17*
0.28***
0.32***
T-value
1.90
3.22
2.62
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H.W. Kot
Institutional Ownership


IH_NO is the number of institutions holding the stock;
IH_RATIO is the proportion of stock held by institutions


the total number of shares held by institutions divided the number of shares outstanding.
Sample stocks: 1985-2003
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Changes in Institutional Ownership (from Table 4)
0.7
300
0.65
250
0.6
200
0.55
150
0.5
100
0.45
50
0.4
t-5 t-4 t-3 t-2 t-1
IH_Ratio (Addition)
85
t t+1 t+2 t+3 t+4 t+5
IH_Ratio (Deletion)
0
t-5 t-4 t-3 t-2 t-1
t t+1 t+2 t+3 t+4 t+5
IH_No (Addition)
IH_No (Deletion)
FINC3003 Chapter 13
H.W. Kot
Analysts



COVERAGE is defined as the number of analysts following a stock;
DISPERSION is the standard deviation of analysts’ annual earnings per share forecasts
for a fiscal year divided by the average of their earnings per share (EPS) forecasts.
Sample stocks: 1979-2003
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Changes in Analyst Coverage (Figure 2)
18
16
14
12
10
8
6
4
2
-60-55-50-45-40-35-30-25-20-15-10 -5 0 5 10 15 20 25 30 35 40 45 50 55 60
Coverage-Addition
87
Coverage-Deletion
FINC3003 Chapter 13
H.W. Kot
Changes in Dispersion of Forecasts (Figure 2)
0.1100
0.1000
0.0900
0.0800
0.0700
0.0600
0.0500
0.0400
0.0300
0.0200
-60-55-50-45-40-35-30-25-20-15-10 -5 0 5 10 15 20 25 30 35 40 45 50 55 60
Dispersion-Addition
88
Dispersion-Deletion
FINC3003 Chapter 13
H.W. Kot
Shadow Costs (×109)
Re sidualS tan dardDevt
FirmSize0
ShadowCost t =

S&P500MarketCap 0
NumberofSh areholderst



89
FirmSize0 (the market value of equity)
S&P500MarketCap0 are measured on the announcement dates of the
index changes.
ResidualStandardDevt is the standard deviation of the difference
between the firm’s return and the S&P 500 total return over a 252-day
period from year t-5 to year t before the index change announcement
for the pre-period, or after the effective day for the post period.
FINC3003 Chapter 13
H.W. Kot
Changes of Shadow Costs (Table 6)
3
2.5
2
1.5
1.2
1
0.5
0.23
0.14
0
-5
-4
-3
-2
-1
Addition
90
0
1
2
3
4
5
Deletion
FINC3003 Chapter 13
H.W. Kot
Operating Performance



Profit Margin is defined as net income divided by sales.
ROA is defined as net income over total assets.
OIBD/Assets is operating income divided by total assets, where operating income is defined as
operating income before depreciation, amortization, and taxes, plus interest income.

(CE+RD)/Assets is capital and R&D expenditures as a proportion of total assets.
M/B is the firm’s market-to-book ratio.

All ratios are adjusted by related industry average.

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Industry-Adjusted Operating Performance Comparison
(Addition stocks, from Table 8)
0.045
0.04
0.035
0.03
OIBD/Assets
0.025
CE+RD/Assets
Profit Margin
0.02
ROA
Market/Book*20
0.015
0.01
0.005
0
-5
92
-4
-3
-2
-1
0
1
2
3
4
5
FINC3003 Chapter 13
H.W. Kot
Industry-Adjusted Operating Performance Comparison
(Deletion stocks, from Table 8)
0.002
0
-5
-4
-3
-2
-1
0
1
2
3
4
5
-0.002
-0.004
OIBD/Assets
-0.006
CE+RD/Assets
-0.008
Profit Margin
ROA
-0.01
Market/Book*20
-0.012
-0.014
-0.016
-0.018
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The long-term performance of index additions and
deletions: Evidence from the Hang Seng Index
Hung Wan Kot, Harry Leung, & Gordon Tang
International Review of Financial Analysis 42 (2015) 407-420
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FINC3003 Chapter 13
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Why Hang Seng Index?


S&P 500 Index: survivorship bias
 Chan, Kot, and Tang (2013): Added vs deleted stocks (788 vs 244)
 Chen, Noronha, and Singal (2004): ¾ of S&P 500 deletions occur due to M&A,
bankruptcies etc.
Hang Seng Index
 Most deleted stocks are still listing on exchange
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FINC3003 Chapter 13
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Hang Seng Index



Start from July 31, 1964; 33 constituent stocks
Quarterly review, 2 stages
 1st : Fulfill 4 objective criteria (including no foreign firms)
 2nd:
1. market cap, turnover ranking;
2. better reflect the subsectors in the market;
3. financial performance
After September 11, 2006
 No. of constituent stocks could increased to a max of 50
 Mainland China firms are eligible
Further study→
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FINC3003 Chapter 13
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Hang Seng Index vs S&P500 Index
S&P 500 Index
Hang Seng Index
Most changes are initiated by
deletions
The majority of changes are because
they can not represent the market
Changes do not occur on a regular
basis
Quarterly review
22 additions/deletions per year
2.1 additions/deletions per year
Announce the changes before the
Announce one month before the
effective dates: from 1 day to 1 month effective date
One deletion match with one addition Not a one-to-one basis
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Sample


All of the additions to and deletions from the HSI from June 1986 to October 2008.
Final sample comprises 44 added stocks and 35 deleted stocks.
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FINC3003 Chapter 13
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Market adjusted buy-and hold returns (Table 2)
Post Event Months
[1, 12]
[1, 60]
Raw returns
0.0747
0.663
Raw-Hang Seng Index
0.0358
0.0055
0.46
0.03
Raw returns
0.0828
1.6636
Raw-Hang Seng Index
0.0455
0.9499***
0.69
3.66
-0.0098
-0.9444***
-0.09
-2.93
Panel A: Additions
T-value
Panel B: Deletions
T-value
Panel C: Difference
Raw-Hang Seng Index (A-B)
T-value
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FINC3003 Chapter 13
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Red-chips, H-shares & Family-owned firms
Additions
Others
Red-chips
& Hshares
Deletions
Familyowned
firms
Diff is significant
Others
Diff is insignificant
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Operating performance






profit margin
return on assets (ROA)
OIBD/assets (operating income before depreciation)
(CE+RD)/assets (capital and R&D expenditures)
M/B
adjusted according to the industry average
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Operating performance (Added stocks, normalized at t-5)
3.5
3
2.5
2
1.5
1
0.5
0
-5
-4
Profit Margin
102
-3
-2
-1
OIBD/Assets
0
1
2
CE+RD/Assets
3
ROA
FINC3003 Chapter 13
4
5
M/B
H.W. Kot
Operating performance (Deleted stocks, normalized at t-5)
3
2.5
2
1.5
1
0.5
0
-5
-4
-3
Profit Margin
103
-2
-1
OIBD/Assets
0
1
CE+RD/Assets
2
3
ROA
FINC3003 Chapter 13
4
5
M/B
H.W. Kot
Changes in analyst coverage (Table 5)
25
23
21
19
17
15
Additions
13
Deletions
11
9
7
5
-5
104
-4
-3
-2
-1
0
1
2
3
4
5
FINC3003 Chapter 13
H.W. Kot
Beta
RETitA / D − R ft =  i +  i (MKTt − R ft ) +  it




RETit is stock i’s return on month t, where A/D refers to whether it belongs to the
addition or the deletion set.
Rf is again the risk-free rate, and
MKT is the monthly return of the HSI.
We compute the betas using monthly data per year from years t-5 to t+5.
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Beta changes (Table 7)
1.6
1.4
1.2
Additions
1
Deletions
0.8
0.6
0.4
-5
-4
-3
-2
-1
0
1
2
Additions
3
4
5
Deletions
Panel B:Significance of difference (t-value)
106
t-5 vs. t
2.59**
-0.14
t vs. t+5
-2.38**
0.88
FINC3003 Chapter 13
H.W. Kot
CSI 300 additions and deletions




Price performance of firms added to or deleted from the CSI 300.
Added and deleted stocks both have abnormal returns over four-year holding
period.
Deleted stocks outperform added stocks
Firm risk, manager overconfidence, and state ownership new identified factors
Long-term impacts of index reconstitutions: Evidence from the CSI 300 additions and deletions,
Gang Chu, John W. Goodell, Xiao Li, Yongjie Zhang, 2021, Pacific-Basin Finance Journal 69, 101651.
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