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 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 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 | iii TABLE OF CONTENTS CHAPTER 1: INTRODUCTION 1.1 PROBLEM STATEMENT: 1.2 RESEARCH OBJECTIVE: 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: 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 LIQUIDITY PREMIUM IN STOCK RETURNS, THE CASE OF VIETNAM Page | iv 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 LIQUIDITY PREMIUM IN STOCK RETURNS, THE CASE OF VIETNAM Page | v LIST OF ABBREVIATIONS HOSE : Ho Chi Minh City Stock Exchange NYSE : New York Stock Exchange EMH : Efficient Market Hypothesis MPT : Modern Portfolio Theory CAPM : Capital Asset Pricing Model SMB : Small minus Big HML : High minus Low CMA : Conservative minus Aggressive RMW : Robust minus Weak FF : Fama and French LIQUIDITY PREMIUM IN STOCK RETURNS, THE CASE OF VIETNAM Page | vi CHAPTER 1: 1.1 INTRODUCTION PROBLEM STATEMENT: This problem statement will firstly discuss about the essential role of stock market in each country as the stock market provides multiple benefits for investors, corporations and country‘s economy Drawing from these benefits, the second paragraph will mention about the establishment of stock market in most countries around the world With the establishment of stock market and involvement of many social parties, stock returns become a special interest for many participants, especially for participants who directly engaged in the market From this realistic need of many social parties about stock returns, the third, fourth and fifth paragraphs are dedicated for discussion about the quest of researchers in studying determinants of stock returns and the emergence of liquidity as one determinant of stock returns The rest of this problem statement will demonstrate that current trend of liquidity research was excessively concentrated on developed market and there is an obvious need to have a thorough research about the influence of liquidity on stock returns in a frontier market, such as Vietnam Stock market is undeniably an integral part of each country economy Stock market provide number of benefits for individual investors, corporations and economy For corporation, stock market allow company to gain access to huge capital market Once the company is listed, it can expand its capital through share issuance In addition, merge and acquisition can be facilitated by share purchase in the stock market For investors, stock market provide investors a channel for investing their money There are many different types of companies which should suit the taste of different investors About economy, the key benefit of stock market is that it promotes economic growth by encouraging investors to put their saving into listed companies As a result, it encourages the companies’ development and promotes economic growth With all of these advantages, stock market has been developed in many countries Developed countries have their stock markets established for over centuries ago With the establishment of stock market and involvement of many social parties, the stock returns become a special interest for many participants, especially for participants who directly involved in the market Specifically, for investors, stock returns is a major factor in deciding where their fund will be invested For corporations, stock return should be a reliable gauge of companies’ performance as investors purchase and sell companies’ stock based on its fundamental and prospect For economy and government, stock return is a dependable barometer for gauging the economic LIQUIDITY PREMIUM IN STOCK RETURNS, THE CASE OF VIETNAM Page | condition of a country The stock price reflects the macroeconomic condition and major changes in country economy The rise and fall of stock price often coincides with economic cycle of a country (Pujari, 2010) As a result, government can observes the health of their stock market and promulgates suitable policies to regulate and develop their own economy From this realistic need, many researchers have been devoting their efforts in studying about determinants of stock returns and its mechanism The literature on stock returns nowadays is incredibly enormous and many scholars still keep searching for unknown determinants and new methodologies In reality, one factor that attracted attention of stock market participants and it has been noticed for a long time, this is liquidity Liquidity is commonly defined as the ability to purchase or sell a large quantity of stocks quickly at low cost without affecting the price significantly (Choe & Yang, 2008) Through many years, investors observed that liquid stock can be easily converted into cash without much difficulties In contrast, illiquid stock caused some level of difficulties for investors when they want to convert the stocks into cash It often requires investors to sell at a lower price or endure a greater transaction cost for the sale With this in mind, investors well aware of the liquidity premium (the price spread between liquid and illiquid stocks) However, there wasn’t any remarkable study about liquidity until the well-known paper of Amihud and Mendelson (1986) Amihud and Mendelson (1986) were the pioneers in liquidity research when they proposed the transaction cost theory In their landmark paper, they found out evidence that there is a significant liquidity premium in asset return Since the publication of this paper, many scholars started to develop this new field of literature Many new proxies for liquidity have been formulated due to the need for measuring liquidity in different stock market After years of liquidity research, some scholars agreed on the view that investors often require a higher rate of stock returns in compensating for illiquidity (Amihud, 2002), (Brennan & Subrahmanyam, 1996), (Brennan, Chordia, & Subrahmanyam, 1998), (Chordia, Roll, & Subrahmanyam, 2000) This basically means liquidity affects negatively on stock returns Nonetheless, there is divergence from the above viewpoint when other researchers found an opposite relationship They claimed that the relationship is actually positive To support this viewpoint, they also had their arguments and empirical researches (Bali, Peng, Shen, & Tang, 2014), (Abzari, Fathi, & Kabiripour, 2013) An important fact is that the majority of researches about liquidity has been conducted in developed financial market, especially in United States (where most of data are available and it is LIQUIDITY PREMIUM IN STOCK RETURNS, THE CASE OF VIETNAM Page | one of the most developed financial market in the world) However, Bekaert, Harvey, and Lundblad (2007) stated that the liquidity effect should be stronger in emerging market than in developed one They stated some rationales for their conclusion The first reason 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 As a result, this would intensify the liquidity premium (frontier market even suffers a greater liquidity gap than emerging market) Secondly, many emerging market went through market liberalization during their research period And this incident should assist researchers in study the importance of liquidity on expected return The reason is that, after liberalization, the liquidity often increases noticeably in comparison with prior liberalization period Thirdly, 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, the diversification in number of securities and ownership is lacked of which often intensify the liquidity effects From above discussion, there is an obvious need for conducting a research about liquidity premium in frontier market, which is considered as a pre-emerging market The first reasons is that there is a divergence in viewpoint among researchers about the influence of liquidity on stock returns In addition, the liquidity gap between liquid and illiquid stocks in frontier market, such as Vietnam, is very significant Last but not least, the number of researches about liquidity in frontier market, especially in Vietnam, are very limited This cannot provide a thorough understanding about the role of liquidity in Vietnam stock market The only paper that I found, which studied the relationship between liquidity and stock returns in Vietnam, is from Xuân Vinh and Hồng Thu (2013) This paper, however, published a positive relationship between liquidity measures and stock returns (a negative relationship between illiquidity measures and stock returns) They provide two rationales for their findings The first rationale is that investors in Vietnam are small and trade frequently They believed this will boost the demand for large and liquid stocks and will create a higher return on these stocks The second rationale is that Vietnamese stock market is a newborn market and there are many newly listed stocks every year These new stocks will create a huge uptrend in price and volume at their Initial Public Offer which cause an increase in both liquidity and stock price I believed their rationale is quite vague and their method for constructing the liquidity measures is different from the well – known method of Fama and French (2013) LIQUIDITY PREMIUM IN STOCK RETURNS, THE CASE OF VIETNAM Page | The reason for small turnover value in the reported table is because it showed the average daily turnover for stocks during a month Furthermore, each observation is the difference between average daily return of high turnover portfolio and average daily return of low turnover portfolio Another noticeable interpretation from the statistic table is that the turnover series has skewness of 0.407 and kurtosis of 3.14 These numbers meant that distribution of turnover data has near symmetrical and normal Gaussian distribution This confirmed that turnover data is well collected and provides reliable result All other variables also have decent values of skewness and kurtosis The only exception is that cumulative 7-12 (RET712) which has high skewness and kurtosis value Overall, the number of observations might be quite small (72 observations) which create troublesome for getting normal distribution sample Nonetheless, the sample has been processed carefully and provides an acceptable range of distribution 4.1.2 Amihud Illiquidity Ratio: Table 11: Turnover regression descriptive statistics AMIHUD RISK SMB HML CMA RMW RET23 RET46 RET712 Mean Median Maximum Minimum Std Dev Skewness Kurtosis -0.010 -0.022 0.470 -0.916 0.233 -0.646 5.381 -0.001 -0.001 0.483 -0.245 0.078 0.797 3.087 0.021 0.008 0.423 -0.258 0.140 0.488 3.601 0.207 0.172 0.922 -0.729 0.277 -0.155 4.118 -0.081 -0.093 0.357 -0.441 0.165 0.453 3.273 0.151 0.134 0.839 -0.670 0.240 -0.344 4.478 0.788 0.764 1.756 0.193 0.317 0.608 3.442 1.118 1.051 2.766 0.302 0.436 0.896 4.765 2.262 2.143 5.373 0.457 0.900 1.531 6.775 The descriptive statistic for Amihud’s illiquidity table is similar to Turnover variable in a sense that all other independent variables are the same, except for turnover measure is changed by the use of Amihud’s illiquidity ratio The skewness indicates a good proportion in sample distribution where there is a near equal distribution between left and right side However, the Kurtosis value of 5.381 indicates a Leptokertic distribution where most of the sample data concentrate close to the mean value LIQUIDITY PREMIUM IN STOCKS, THE CASE OF VIETNAM Page 54 4.2 ECONOMETRIC RESULTS: 4.2.1 Empirical Results for Turnover Measure: All the econometric result tables in this part will contain four different regressions The first regression will include all explanatory variables The second and third regressions will separate two potential multicollinearity variables into two different regressions The final regression for each liquidity measure will drop all possible multicollinearity variables This will alleviate the multicollinearity issue and help estimating the effect of liquidity measure on stock return precisely Independent Table 12: Empirical result of Turnover Measure REGRESSION RESULT OF TURNOVER Variables Regression Regression Regression Regression TURNOVER -0.113** -0.135* -0.113* -0.136* (t – stat) -2.677 -3.975 -2.700 -4.085 RISK -0.005 -0.005 -0.006 -0.007 (t – stat) -0.362 -0.349 -0.404 -0.459 SMB 0.024* 0.024* 0.025* 0.024* (t – stat) 3.934 3.657 4.004 3.729 HML 0.197* 0.184* 0.198* 0.186* (t – stat) 8.677 9.689 9.324 10.636 CMA -0.052* -0.052* (t – stat) -4.241 -4.321 RMW 0.151* 0.151* (t – stat) 10.879 10.324 RET23 0.064 0.058 0.068 0.067 (t – stat) 0.630 0.569 0.729 0.680 RET46 0.105 0.104 0.109*** 0.115*** (t – stat) 1.430 1.315 1.710 1.707 RET712 -0.042 -0.187 -0.051 -0.213 (t – stat) -0.152 -0.955 -0.195 -1.209 Adj R-squared S.E regression Sum sq residual 0.789 0.032 0.04 F-statistic 0.779 0.033 0.043 0.795 0.032 0.04 0.784 0.033 0.043 Durbin-Watson 1.757 1.728 1.765 1.758 *, **, *** represent significant at 1% level, 5% level and 10% level, respectively LIQUIDITY PREMIUM IN STOCKS, THE CASE OF VIETNAM Page 55 Base on some common indicators of each regression, some observations can be drawn out All regressions showed a similar value of adjusted R-squared, S.E of regression and sum square residual In another aspect, Durbin Watson stat, which is an indicator of autocorrelation, suggested that third regression suffer less from autocorrelation issue than other regressions To sum up, the third and fourth regressions provide most reliable results when they both have highest R-squared and Durbin Watson stat Nonetheless, there is a trade-off in selecting either two models which depend on the priority of users From the regression result of table 12, it can be observed that all the regressions strongly support the role of turnover in explaining stock returns Firstly, all these models indicate that the empirical results of turnover are at least significant at 5% level which is a high significant level Secondly, the last regression, where CMA and RMW aren’t included, showed a very high level of confidence that Turnover is a premium factor for explaining stock return Furthermore, Durbin Watson stats are close to which means these regressions only suffer slightly from autocorrelation issue LIQUIDITY PREMIUM IN STOCKS, THE CASE OF VIETNAM Page 56 4.2.2 Empirical Results for Amihud’s Illiquidity Measure: Table 13: Empirical result of Amihud’s Illiquidity Ratio Independent REGRESSION RESULT OF AMIHUD RATIO Variables Regression Regression Regression Regression AMIHUD 0.083** 0.098* 0.122* 0.122* (t – stat) 2.056 3.369 3.371 4.971 RISK -0.005 -0.005 0.001 0.001 (t – stat) -0.334 -0.345 0.079 0.080 SMB 0.026* 0.024* (t – stat) 3.643 2.804 HML 0.202* 0.200* (t – stat) 8.826 8.628 CMA -0.051* -0.051* -0.061* -0.061* (t – stat) -4.168 -4.042 -5.546 -5.379 RMW 0.151* 0.151* 0.161* 0.161* (t – stat) 10.756 10.891 8.646 8.750 RET23 0.059 0.067 0.034 0.035 (t – stat) 0.597 0.658 0.331 0.334 RET46 0.095 0.102 0.078 0.079 (t – stat) 1.307 1.536 0.921 0.977 RET712 -0.001 -0.011 -0.189 -0.189 (t – stat) -0.004 -0.032 -0.696 -0.703 Adj R-squared S.E regression Sum sq residual 0.789 0.033 0.040 0.792 0.032 0.041 0.753 0.035 0.048 0.759 0.035 0.048 Prob (F-statistic) 0 0 Durbin-Watson 1.787 1.753 1.566 1.565 *, **, *** represent significant at 1% level, 5% level and 10% level, respectively In this case of Amihud illiquidity ratio, it can be observed that adjusted R-squared, S.E of regression and Sum of square residuals are quite similar between all four regressions The regressions of Amihud illiquidity ratio showed some discrepancies in their results The first model, which included all control variables, showed the Amihud illiquidity ratio is only significant at 5% level However, the second, third and fourth regressions showed that LIQUIDITY PREMIUM IN STOCKS, THE CASE OF VIETNAM Page 57 Amihud illiquidity ratio is highly significant at 1% level Judging by R-squared and Durbin Watson stat, the first and the second regressions should provide the most reliable results in all four regressions Overall, all of these regressions support the role of Amihud illiquidity ratio in explain stock returns 4.3 DISCUSSIONS: In this study, the main purpose is to examine the effect of liquidity on stock return There are two representative measures of liquidity in this study, namely turnover and Amihud illiquidity ratio For turnover, the empirical result strongly supports the role of turnover in explaining stock return All four regressions of turnover measure indicate a negative relationship between turnover and stock returns Moreover, they are all significant at and below 5% level which are reliable results This negative relationship between turnover and stock returns is in agreement with the main hypothesis of this study and support by well-known researchers in liquidity The first to mention is Amihud and Mendelson (1986) who were considered as the pioneer in liquidity research They introduced the transaction cost theory which supports negative relationship between liquidity and stock return The basic notion behind this theory is that investors require a premium over illiquid stocks because they incur a higher transaction cost than liquid stocks Another explanation for negative relationship is a difference in trading horizon of investors Illiquid stock is often kept by investors for a longer time horizon than liquid stocks Moreover, the risk of illiquid stocks also higher than liquid stocks when the same risk in illiquid stocks are shared by less investors than liquid stocks As a result, investors command a higher premium for holding illiquid stock in their portfolio Another liquidity measure is Amihud illiquidity ratio All of the four empirical regressions pointed to a same conclusion that Amihud illiquidity ratio has a positive relationship with stock returns All of the results are reliable as they are already treated for common issues in panel data (heteroscedasticity, autocorellation, multicollinearity…etc.) Despite the first regression is only significant at 5% level, all other regressions are significant at 1% level which is very strong indication of this relationship Because Amihud ratio is an illiquidity measure, so that their expected sign will reverse with the sign of Turnover measure The rationale behind this positive relationship is similar to turnover measure With very persuasive results from two proxies of liquidity, this thesis conclude that there is a negative influence of liquidity on stock returns in Vietnam market The findings of negative relationship between liquidity and stock returns in Vietnam is in contrary with findings in paper of Vo and Batten (2011), Xuân Vinh and Hồng Thu (2013) In these papers, they claimed a positive relationship between two variables in the case of LIQUIDITY PREMIUM IN STOCKS, THE CASE OF VIETNAM Page 58 Vietnam However, the result from this thesis should be more reliable when all the data are collected from trusted source In addition, all data is treated and followed strictly the procedure of Fama and French in constructing portfolios and factors Furthermore, the empirical result from this thesis show a reasonable effect of two liquidity measures on stock returns while these papers showed extremely large or small effects of different liquidity measures on stock returns Last but not least, the result from this thesis is in agreement with basic theories as well as viewpoint of well-known researchers This demonstrated a very important role of selecting a right methodology for each research as the outcome could be very different despite the same time frame and research location Although the primary purpose of this research wasn’t to investigate the effect of Fama and French factors on stock returns, this research also demonstrates that Fama and French (2013)’s factors were very effective in explaining stock returns Particularly, SMB factor has 1% significant level in both set of regressions (regressions on Turnover and Amihud ratio) The positive sign of SMB factor was also in agreement with theory of Fama and French in which they claimed that small firms should be more vulnerable to various risks than big firms due to their relative small size and undiversified nature About HML factor, the result was very encouraging when their t statistic in both set of regressions was around Their positive sign was also in agreement with Fama and French expectation as high B/M ratio means the value of company in public market has decreased due to current business condition and low expected future earnings Therefore, investors require an extra compensation above normal return for investing in such companies Interestingly, the regression result from this thesis showed a negative relationship between CMA factor and stock returns This means that stock return from low investment companies (conservative companies) will actually less than the stock return of high investment companies (aggressive companies) This result diverges from expected sign of Fama and French when they expected high growth in book equity companies (high investment) should imply lower expected return The specific explanation for this result might be high investment firms in Vietnam are expected to provide higher future earnings and market evaluates their stock at a higher price for their potential The last Fama and French factor is RMW also proved to be effective in explaining stock return with its t-statistic around 10 The positive sign from this research is in alignment with expected sign from Fama and French theory In Fama and French theory, stock returns from higher expected earning firms would be more than returns from low expected earning firms And this make sense as investors would be willing to pay higher price for purchasing high LIQUIDITY PREMIUM IN STOCKS, THE CASE OF VIETNAM Page 59 expected earning stocks, thus they will push up the stock price which result in higher stock returns for its holders According to the empirical result of this thesis, the cumulative return measure didn’t play a significant role in explaining stock returns as all three cumulative variables have insignificant level of confidence This simply means the stock that delivers a high return in past will not necessarily deliver a high return in current month The effectiveness of this cumulative returns measure is quite controversial as empirical results of this measure in different stock market yielded diverse conclusion about its effectiveness LIQUIDITY PREMIUM IN STOCKS, THE CASE OF VIETNAM Page 60 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 LIQUIDITY PREMIUM IN STOCKS, THE CASE OF VIETNAM Page 61 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 LIQUIDITY PREMIUM IN STOCKS, THE CASE OF VIETNAM Page 62 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 LIQUIDITY PREMIUM IN STOCKS, THE CASE OF VIETNAM Page 63 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? Cahier de recherche n, 05 Amihud, Y (2002) Illiquidity and stock returns: cross-section and time-series effects Journal of financial markets, 5(1), 31-56 Amihud, Y., & Mendelson, H (1986) Asset pricing and the bid-ask spread Journal of financial economics, 17(2), 223-249 Amihud, Y., Mendelson, H., & Lauterbach, B (1997) Market microstructure and securities values: Evidence from the Tel Aviv Stock Exchange Journal of financial economics, 45(3), 365-390 Baker, M., & Stein, J C (2004) Market liquidity as a sentiment indicator Journal of financial markets, 7(3), 271-299 Bali, T G., Peng, L., Shen, Y., & Tang, Y (2014) Liquidity shocks and stock market reactions Review of Financial Studies, 27(5), 1434-1485 Banz, R W (1981) The relationship between return and market value of common stocks Journal of financial economics, 9(1), 3-18 Basu, S (1977) Investment performance of common stocks in relation to their price‐earnings ratios: A test of the efficient market hypothesis The journal of Finance, 32(3), 663682 Bekaert, G., Harvey, C R., & Lundblad, C (2007) Liquidity and expected returns: Lessons from emerging markets Review of Financial Studies, 20(6), 1783-1831 Bennaceur, S., & Chaibi, H (2007) The best asset pricing model for estimating cost of equity: evidence from the stock exchange of Tunisia SSRN Papers Black, F (1998) Beta and return Streetwise: The Best of the Journal of Portfolio Management, 74 Brailsford, T., Gaunt, C., & O'Brien, M A (2012) The investment value of the value premium Pacific-Basin Finance Journal, 20(3), 416-437 Brennan, M J., Chordia, T., & Subrahmanyam, A (1998) Alternative factor specifications, security characteristics, and the cross-section of expected stock returns Journal of financial economics, 49(3), 345-373 Brennan, M J., & Subrahmanyam, A (1995) Investment analysis and price formation in securities markets Journal of financial economics, 38(3), 361-381 Brennan, M J., & Subrahmanyam, A (1996) Market microstructure and asset pricing: On the compensation for illiquidity in stock returns Journal of financial economics, 41(3), 441-464 Carhart, M M (1997) On persistence in mutual fund performance The journal of Finance, 52(1), 57-82 Choe, H., & Yang, C.-W (2008) Comparisons of Liquidity Measures in the Stock Markets Chordia, T., Roll, R., & Subrahmanyam, A (2000) Commonality in liquidity Journal of financial economics, 56(1), 3-28 Chordia, T., Subrahmanyam, A., & Anshuman, V R (2001) Trading activity and expected stock returns Journal of financial economics, 59(1), 3-32 Cooper, S K., Groth, J C., & Avera, W E (1985) Liquidity, exchange listing, and common stock performance Journal of Economics and Business, 37(1), 19-33 LIQUIDITY PREMIUM IN STOCKS, THE CASE OF VIETNAM Page 64 Daniel, K., & Titman, S (1997) Evidence on the characteristics of cross sectional variation in stock returns The journal of Finance, 52(1), 1-33 Datar, V T., Naik, N Y., & Radcliffe, R (1998) Liquidity and stock returns: An alternative test Journal of financial markets, 1(2), 203-219 Dempsey, M (2013) The Capital Asset Pricing Model (CAPM): The History of a Failed Revolutionary Idea in Finance? Abacus, 49(S1), 7-23 Drew, M (2003) Beta, firm size, book-to-market equity and stock returns Journal of the Asia Pacific Economy, 8(3), 354-379 Easley, D., Kiefer, N M., O'hara, M., & Paperman, J B (1996) Liquidity, information, and infrequently traded stocks The journal of Finance, 51(4), 1405-1436 Eleswarapu, V R (1997) Cost of transacting and expected returns in the Nasdaq market The journal of Finance, 52(5), 2113-2127 Eleswarapu, V R., & Reinganum, M R (1993) The seasonal behavior of the liquidity premium in asset pricing Journal of financial economics, 34(3), 373-386 Fama, E F (1965) The behavior of stock-market prices Journal of business, 34-105 Fama, E F (1970) Efficient capital markets: A review of theory and empirical work* The journal of Finance, 25(2), 383-417 Fama, E F., & French, K R (1992) The cross‐section of expected stock returns The journal of Finance, 47(2), 427-465 Fama, E F., & French, K R (1993) Common risk factors in the returns on stocks and bonds Journal of financial economics, 33(1), 3-56 Fama, E F., & French, K R (2013) A five-factor asset pricing model Fama-Miller working paper, University of Chicago, Dartmouth College and NBER Fama, E F., & MacBeth, J D (1973) Risk, return, and equilibrium: Empirical tests The Journal of Political Economy, 607-636 Greenwood, R., & Nagel, S (2009) Inexperienced investors and bubbles Journal of financial economics, 93(2), 239-258 Harvey, C R (1995) Predictable risk and returns in emerging markets Review of Financial Studies, 8(3), 773-816 Jegadeesh, N., & Titman, S (1993) Returns to buying winners and selling losers: Implications for stock market efficiency The journal of Finance, 48(1), 65-91 Jensen, M C., Black, F., & Scholes, M S (1972) The capital asset pricing model: Some empirical tests Jun, S.-G., Marathe, A., & Shawky, H A (2003) Liquidity and stock returns in emerging equity markets Emerging Markets Review, 4(1), 1-24 Kane, A (1994) Trading cost premiums in capital asset returns—a closed form solution Journal of Banking & Finance, 18(6), 1177-1183 Kyle, A S (1985) Continuous auctions and insider trading Econometrica: Journal of the econometric society, 1315-1335 L’Her, J.-F., Masmoudi, T., & Suret, J.-M (2004) Evidence to support the four-factor pricing model from the Canadian stock market Journal of International Financial Markets, Institutions and Money, 14(4), 313-328 Lam, K (2005) Is the Fama-French three factor model better than the CAPM? , Department of Economics-Simon Fraser University Lam, K S (2002) The relationship between size, book-to-market equity ratio, earnings– price ratio, and return for the Hong Kong stock market Global Finance Journal, 13(2), 163-179 Lam, K S., Li, F K., & So, S M (2010) On the validity of the augmented Fama and French’s (1993) model: evidence from the Hong Kong stock market Review of Quantitative Finance and Accounting, 35(1), 89-111 LIQUIDITY PREMIUM IN STOCKS, THE CASE OF VIETNAM Page 65 Lesmond, D A., Ogden, J P., & Trzcinka, C A (1999) A new estimate of transaction costs Review of Financial Studies, 12(5), 1113-1141 Lintner, J (1965) The valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets The review of economics and statistics, 13-37 Liu, W (2006) A liquidity-augmented capital asset pricing model Journal of financial economics, 82(3), 631-671 Markowitz, H (1952) Portfolio selection* The journal of Finance, 7(1), 77-91 Miller, M H., & Modigliani, F (1961) Dividend policy, growth, and the valuation of shares the Journal of Business, 34(4), 411-433 Mossin, J (1966) Equilibrium in a capital asset market Econometrica: Journal of the econometric society, 768-783 Newey, W K., & West, K D (1986) A simple, positive semi-definite, heteroskedasticity and autocorrelationconsistent covariance matrix: National Bureau of Economic Research Cambridge, Mass., USA Novy-Marx, R (2013) The other side of value: The gross profitability premium Journal of financial economics, 108(1), 1-28 O'Brien, M A., Brailsford, T., & Gaunt, C (2008) Size and book-to-market factors in Australia Paper presented at the 21st Australasian Finance and Banking Conference Petersen, M A (2009) Estimating standard errors in finance panel data sets: Comparing approaches Review of Financial Studies, 22(1), 435-480 Pujari, S (2010) Some important function of stock exchange market Retrieved 25 May, 2015 Roll, R (1977) A critique of the asset pricing theory's tests Part I: On past and potential testability of the theory Journal of financial economics, 4(2), 129-176 Roll, R (1984) A simple implicit measure of the effective bid‐ask spread in an efficient market The journal of Finance, 39(4), 1127-1139 Rouwenhorst, K G (1999) Local return factors and turnover in emerging stock markets The journal of Finance, 54(4), 1439-1464 Savoiu, G (2013) Some Characteristics of the Financial Data Series Romanian Statistical Review, 4, 12 Sharpe, W F (1964) Capital asset prices: A theory of market equilibrium under conditions of risk* The journal of Finance, 19(3), 425-442 Subrahmanyam, A (2010) The Cross‐Section of Expected Stock Returns: What Have We Learnt from the Past Twenty‐Five Years of Research? 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) LIQUIDITY PREMIUM IN STOCKS, THE CASE OF VIETNAM Page 66 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  i, Fk is an estimate of βs for each asset or portfolio for each F risk factor The  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) LIQUIDITY PREMIUM IN STOCKS, THE CASE OF VIETNAM Page 67  The  is kept unchanged for each portfolio in all the cross sectional regressions from 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 γk coefficient represents factor premium for an average exposure to  i, Fk of The 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 LIQUIDITY PREMIUM IN STOCKS, THE CASE OF VIETNAM Page 68 ... improve the validity in final conclusion of this thesis LIQUIDITY PREMIUM IN STOCK RETURNS, THE CASE OF VIETNAM Page | The basic procedure for constructing premium factor includes three main phases... life Their contribution is enormous and I can never pay back this LIQUIDITY PREMIUM IN STOCK RETURNS, THE CASE OF VIETNAM Page | ii ABSTRACT Research about the role of liquidity in explaining stock. .. portfolio should reduce the pricing of liquidity In case of emerging markets, the diversification in number of securities and ownership is lacked of which often intensify the liquidity effects From