Liquidity premium in stock returns, the case of vietnam

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES HO CHI MINH CITY THE HAGUE VIETNAM THE NETHERLANDS VIETNAM – NETHERLANDS PROGRAM FOR MA IN DEVELOPMENT ECONOMICS LIQUIDITY PREMIUM IN STOCK RETURNS, THE CASE OF VIETNAM A thesis submitted in partial fulfilment of the requirement for the degree of MASTER OF ART IN DEVELOPMENT ECONOMICS By TRẦN QUANG DUY Academic supervision Dr PHẠM PHÚ QUỐC HO CHI MINH CITY, December 2015 DECLARATION It is to certify that this thesis entitled “Liquidity premium in stock returns, the case of Vietnam” meet all requirements for the Master Degree of Art in Development Economics This thesis and all contents presented in it are developed by me as my own original research It is neither in part nor in whole been presented for another degree elsewhere Trần Quang Duy …………………………… ……………………………… (Author’s name) (Signature) (Date) LIQUIDITY PREMIUM IN STOCK RETURNS, THE CASE OF VIETNAM Page | i LIQUIDITY PREMIUM IN STOCK RETURNS, THE CASE OF VIETNAM Page | i ACKNOWLEDGEMENT Firstly, I would like to express my profound appreciation to my supervisor, Dr Phạm Phú Quốc He has kindly guided and shared with me his experience as well as knowledge about conducting a research He always reminded me and assist me in selecting the right path for my thesis I also would like to say thank to Dr Võ Hồng Đức, who initially shared with me the idea about research in stock returns My special thanks to Nguyễn Duy Tân and Võ Thế Anh, who dedicated their time and effort in helping me attain the huge data set for this thesis as well as overcame number of obstacles during my thesis I would like to express my sincere gratitude toward all lectures and staffs in Vietnam Netherlands program for their kindness and dedication in teaching and providing the best study environment Furthermore, I would like to say thank to all my friends in the course of my study at this program We have studied and been through many subjects, assignments together They always beside and remind me whenever I feel discouragement so that I can finally finish this thesis Last but not least, I am indebted to my parents who gave me all the love and support for every steps of my life Their contribution is enormous and I can never pay back this LIQUIDITY PREMIUM IN STOCK RETURNS, THE CASE OF VIETNAM Page | ii LIQUIDITY PREMIUM IN STOCK RETURNS, THE CASE OF VIETNAM Page | ii ABSTRACT Research about the role of liquidity in explaining stock returns has mainly been conducted in developed market and yielded ambiguous conclusion about its explanatory power From this gap in literature, this empirical research is conducted to examine the influence of liquidity on stock returns in Vietnam stock market, a frontier market From literature of liquidity and stock returns, there are number of available proxies for liquidity In this research, Turnover and Amihud illiquidity ratio are selected as two main liquidity proxies These two proxies were selected because they showed a great consistency and reliability among available liquidity proxies for empirical research This study also includes some common explanatory variables in stock return literature as control variables in empirical regressions These variables are five premium factors of Fama and French as well as cumulative returns factor All of these factors are constructed by using portfolio formation method of Fama and French The sample for this research includes all non- financial firms in Ho Chi Minh stock exchange (HOSE) for period 2007 to 2013 The regression method is Fama MacBeth which is often employed in finding stock returns This research reveals some noticeable findings Firstly, liquidity negatively related to stock returns This finding was reliable as two liquidity proxies point to the same conclusion Secondly, all Fama and French factors showed that they are very effective in explain stock returns as all these variables present very convincing results Thirdly, the empirical result from this study fail to support the role cumulative return factor in explaining stock returns in Vietnam Key words: Fama and French factors, turnover measure, Amihud illiquidity ratio, stock returns, Fama McBeth regression, listed companies, SMB, HML, CMA, RMW LIQUIDITY PREMIUM IN STOCK RETURNS, THE CASE OF VIETNAM Page | LIQUIDITY PREMIUM IN STOCK RETURNS, THE CASE OF VIETNAM Page | TABLE OF CONTENTS CHAPTER 1: INTRODUCTION 1.1 PROBLEM STATEMENT 1.2 RESEARCH OBJECTIVE: .4 1.3 RESEARCH QUESTION: 1.4 RESEARCH SCOPE 1.5 RESEARCH METHODOLOGY: 1.6 THE STRUCTURE OF THIS THESIS CHAPTER 2: 2.1 LITERATURE REVIEW FUNDAMENTAL THEORIES .7 2.1.1 The Efficient Market Hypothesis: 2.1.2 Modern Portfolio Theory 2.1.3 The Capital Asset Pricing Model: 11 2.2 ASSET RETURNS LITERATURE: 13 2.2.1 Theoretical vs Data Mining Research: 13 2.2.2 Fama – French Three Factors Model: 14 2.2.3 Carhart Four Factors Model: 17 2.2.4 Fama – French Five Factors Model: 18 2.3 LIQUIDITY LITERATURE: 21 2.3.1 Transaction Cost Theory 22 2.3.2 Subsequent Development in Liquidity research: 24 2.4 MAIN HYPOTHESIS 27 CHAPTER 3: 3.1 DATA AND METHODOLOGY 29 REGRESSION MODEL AND RESEARCH FRAMEWORK: 29 3.1.1 Regression Models: 29 3.1.2 Research Framework: 31 3.2 DATA 31 3.3 REGRESSION METHOD: 31 3.4 VARIABLES 32 3.4.1 Dependent Variables: 32 3.4.2 Explanatory Variables: 32 3.4.3 3.5 Control Variables: 37 DATA PROCESSING 38 3.5.1 Primary Data Calculation .38 3.5.2 Factor Construction: 40 3.6 SOLVING POTENTIAL ECONOMETRIC ISSUES 46 3.6.1 Dealing with Heteroscedasticity and Autocorrelation: 46 3.6.2 Dealing with Multicollinearity .47 CHAPTER 4: 4.1 DATA ANALYSIS AND RESULTS 53 DESCRIPTIVE STATISTIC 53 4.1.1 Turnover Measure 53 4.1.2 Amihud Illiquidity Ratio: .54 4.2 ECONOMETRIC RESULTS 55 4.2.1 Empirical Results for Turnover Measure .55 4.2.2 Empirical Results for Amihud’s Illiquidity Measure .57 4.3 DISCUSSIONS 58 CHAPTER 5: CONCLUSION 61 5.1 OVERVIEW 61 5.2 EMPIRICAL RESULTS 61 5.3 CONTRIBUTIONS .62 5.4 IMPLICATIONS 62 5.5 LIMITATIONS AND FUTURE RESEARCH SUGGESTION 63 REFERENCE .64 APPENDIX 67 APPENDIX 1: TWO STAGE FAMA MACBETH REGRESSION 67 CHAPTER 5: 5.1 CONCLUSION OVERVIEW: The main focus of this paper is to study the influence of liquidity on stock returns in Vietnam market, a frontier market The sample data for this thesis was collected from nonfinancial firms in Ho Chi Minh City stock exchange (HOSE) for period 2007-2013 The data was then processed following Fama and French method to provide input variables for this thesis Two main proxies for liquidity are Turnover ratio and Amihud illiquidity ratio These proxies showed a great consistency as they pointed to the same conclusion with high level of confidence In order to obtain a reliable empirical result, Fama MacBeth regression method, Heteroskedasticity and Autocorrelation Consistent (HAC) Standard Errors were employed to solve common issues in financial research data 5.2 EMPIRICAL RESULTS: The empirical test from this thesis show some remarkable results Firstly, from the regression results of two liquidity proxies, this study concludes that liquidity has a negative influence on stock returns in the case of Vietnam, a frontier market The founded negative relationship between liquidity and stock returns is confirmed by transaction cost theory (Amihud & Mendelson, 1986) which stated that investors require a premium over illiquid stocks because these stocks often have higher transaction cost than liquid ones This negative effect also support by Bekaert et al (2007) since they stated that the liquidity effect should be stronger in emerging market The reasons is that poor liquidity was the main factor that prevented foreign institutional investors from invest their money into different types of stock in emerging market (frontier market even suffers a greater liquidity gap than emerging market) As a result, this would intensify the liquidity premium Additionally, developed markets often have diversified ownership structure with both long term and short term investors Thus, Bekaert et al (2007) suggest the clientele effects in selecting investment portfolio should reduce the pricing of liquidity In case of emerging markets and frontier markets, the diversification in number of securities and ownership is lacked of which often intensify the liquidity effect The main finding of this thesis is summarized in table 14 Table 14: Main Finding of the Thesis Research Question Does liquidity influence on stock returns? YES Hypothesis Liquidity negatively influences on stock returns SUPPORT Secondly, although Fama and French’s factors aren’t the main focus of this research, the regression results greatly support the role of Fama and French’s factors in explaining stock returns Particularly, there are positive relationships between SMB, HML, RMW factors and stock returns CMA is the only Fama and French’s factor which negatively related to stock returns Thirdly, the thesis also test the possible influence of cumulative past returns on current return However, the result is not very supportive when two out of three cumulative variables showed insignificant level of confidence RET46 is the only cumulative return variable that has significant level at 10% Nonetheless, this result did not keep consistent through all regressions 5.3 CONTRIBUTIONS: The thesis contributes in some aspects into the literature of asset returns The negative relationship between liquidity and stock returns shows that, in Vietnam, the liquidity premium does exist The empirical test showed a high significance level of confidence for both liquidity proxies with the liquidity premium about 0.1% for each 1% of excess return This result is in contrary with the finding of previous researchers ((Vo & Batten, 2011),(Xuân Vinh & Hồng Thu, 2013)) about liquidity and stock returns in Vietnam when they claimed that the there is a positive relationship between liquidity and stock returns in Vietnam The negative influence of liquidity on stock return also reinforces the claim of Bekaert et al (2007) in the case of frontier market as frontier markets even suffer a greater shortage of liquidity than emerging markets 5.4 IMPLICATIONS: The findings from this research also suggest solutions for different social parties Investors is the first party who can gain benefits from these finding Particularly, they should be conscious about illiquid stocks as these stocks are risker than liquid ones As a result, investment in illiquid stocks should offer a higher return in compensation for withstanding extra liquidity risk Secondly, this finding also imply that companies with illiquid stocks are either small size or excessively control by large shareholders Therefore, the available stocks in the market is only a small portion of its total outstanding shares This cause higher risk for investors who are not insiders of these companies To solve this problem, stock listed companies should ensure a limit for large shareholders in their companies which also reduce the tendency of excessive control Thirdly, government and State Securities commission of Vietnam should establish new policies which can improve the liquidity in Vietnam stock market, so that, stock market can attract more prospective investors as the liquidity risk would be reduced Some suggestive policies are: shorten the transaction time frame to T+2 (the current payment and stock transfer is T+3), decrease and set upper limit for holding percentages of company shares 5.5 LIMITATIONS AND FUTURE RESEARCH SUGGESTION: Despite the empirical result of this study provide some valuable findings about the relationship between liquidity, Fama and French factors and stock returns in Vietnam market The research did experience some drawbacks within itself Firstly, the time frame for research is only years from 2007 to 2013, so that number observations is quite small and might reduce reliability of the result Secondly, there is multicollinearity between explanatory variables, which inflates variance and standard errors of OLS estimators, create wilder confident intervals…etc This problem has been dealt with but certainly, it still effects the interpretation of final result Finally, the control variables used in this study only limit to common factors in stock return literature and the intercept from empirical regressions is not equal zero This means the models in this empirical research cannot fully explain the stock returns and there are other influential factors in explaining stock returns in Vietnam This leaves open space for future research about stock returns in Vietnam market, which is still at early stage of development REFERENCE Abzari, M., Fathi, S., & Kabiripour, V (2013) The Effect of Illiquidity on Capital Gain: Evidence from Iran Aharoni, G., Grundy, B., & Zeng, Q (2013) Stock returns and the Miller Modigliani valuation formula: Revisiting the Fama French analysis Journal of financial economics, 110(2), 347-357 Ajili, S (2003) Explaining the Cross-Section Returns in France: Characteristics or Covariances? 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European Financial Management, 16(1), 27-42 Titman, S., Wei, K C J., & Xie, F (2004) Capital Investments and Stock Returns The Journal of Financial and Quantitative Analysis, 39(4), 677-700 doi: 10.2307/30031881 Vo, X V., & Batten, J (2011) An Empirical Investigation of Liquidity and Stock Returns Relationship in Vietnam Stock Markets during Financial Crisis Xuân Vinh, V., & Hồng Thu, B (2013) Liquidity, Liquidity Risk and Stock Returns– Evidence from Vietnam Bùi, Liquidity, Liquidity Risk and Stock Returns–Evidence from Vietnam (November 1, 2013) APPENDIX APPENDIX 1: TWO STAGE FAMA MACBETH REGRESSION For better understand of the procedure, we first assumed that we have n assets or excess return portfolios over a period of time (Ri,t) The potential explanatory factors will be denoted as F1,t, F2,t, …., Fm,t In the first stage of Fama MacBeth regression, each asset or portfolio is regressed against the proposed explanatory factors Therefore, an equal number of time series regression to the number of assets or portfolios will be run An illustration of these equations are depicted below: R1,t = α1 + β1,F1 F1,t + β1,F2 F2,t + … + β1,Fm Fm,t + ε1,t R2,t = α2 + β2,F1 F1,t + β2,F2 F2,t + … + β2,Fm Fm,t + ε2,t ……… R1,t = αn + βn,F1 F1,t + βn,F2 F2,t + … + βn,Fm Fm,t + εn,t Equations (25) After regressing these time series, the influence of each explanatory factor on the excess return portfolios is recognized individually This is due to the fact that each time series was performed separately with the same number of explanatory factors However, the reward premium to each factor exposure is still not realized until a second stage of Fama MacBeth Regression is implemented Some brief descriptions of variables involving the second stage of Fama MacBeth regression The  i, Fk is an estimate of βs for each asset or portfolio for each F risk factor  difference between these two variables is that is a true unobservable factor load while is an estimation of the true β and derived from time series regression in first stage of Fama MacBeth regression The factor premium for each factor is founded by regressing the following set of cross – sectional regressions:       Ri,1 = ɑ1 + γ1,1 i, F1 + γ2,1 i, F2 + … + γm,1 i, Fm + e1 Ri,2 = ɑ2 + γ1,2 i, F1 + γ2,2 i, F2 + … + γm,2 i, Fm + e2 ……………    Ri,T = ɑT + γ1,T i, F1 + γ2,T i, F2 + … + γm,T i, Fm + eT Equations (26)  from The is kept unchanged for each portfolio in all the cross sectional regressions the first to the final cross sectional regressions The only difference is the change of each asset or portfolio return in each cross sectional regression over different time period The risk premium for each factor is then computed by averaging all the γj,t term into a single γj The standard error for γj is calculated by considering each γj,t as an independent component and compute its t – statistic (the t – statistic of whether γj is statistically different from zero) with below formula: j jt / T (27) jt is the standard deviation of the γj,t term WHY FAMA MACBETH TWO STAGE REGRESSION IS EMPLOYED:  The The γk coefficient represents factor premium for an average exposure to i, Fk of question arose is that why we have to use such a lengthy and demand procedure instead of using only one single cross – sectional regression that involve the average return of all assets or portfolios over time If only one single cross sectional regression was in use, we would expect to have below comparative equation: E(Ri,t) = E(ɑi) + E(βi,F1 F1,t ) + E(βi,F2 F2,t) + … + E(βi,Fm Fm,t) Ri = ɑ + βi,F1 E(F1,t) + βi,F2 E(F2,t) + …+ βi,Fm E(Fm,t) Ri = ɑ + γ1βi,F1 + γ2βi,F2 + … + γmβi,Fm Equations (28) Notice that ɑ is equal to E(ɑi), γk is equal to E( Fk,t), Ri is equal to E( Ri,t) According to the derivation of above equation, it can be recognized that the γk is equal to E(Fk,t) ( the mean or expected value of tradable factor is equal to factor premium) which is the whole purpose of our lengthy and demand task The reason for using such a procedure is that as the sample size approaches the infinity, the true mean (or true expected value) of the factor will be approximately the sample mean of this factor Nonetheless, a sufficient time period to derive the true expected value of the factor is unknown, therefore, Fama - MacBeth regression provide an indirect method to solve the problem without having sufficient sample period ... steps of my life Their contribution is enormous and I can never pay back this LIQUIDITY PREMIUM IN STOCK RETURNS, THE CASE OF VIETNAM Page | ii LIQUIDITY PREMIUM IN STOCK RETURNS, THE CASE OF VIETNAM. .. SMB, HML, CMA, RMW LIQUIDITY PREMIUM IN STOCK RETURNS, THE CASE OF VIETNAM Page | LIQUIDITY PREMIUM IN STOCK RETURNS, THE CASE OF VIETNAM Page | TABLE OF CONTENTS CHAPTER 1: INTRODUCTION ... to examine the influence of liquidity on stock returns in Vietnam stock market, a frontier market From literature of liquidity and stock returns, there are number of available proxies for liquidity