Expiration day effects of Taiwan index futures: The case of the Singapore and Taiwan Futures Exchanges

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Int. Fin. Markets, Inst. and Money 18 (2008) 107–120

Expiration day effects of Taiwan index futures: The case of the Singapore and Taiwan Futures Exchanges Huimin Chung a , Mei-Maun Hseu b,c,∗ a

National Chiao Tung University, HsinChu 300, Taiwan Tamkang University, Tamsui, Taipei County 251, Taiwan Chihlee Institute of Technology, Taipei County 220, Taiwan

b c

Received 13 July 2005; accepted 29 June 2006 Available online 26 September 2006

Abstract This paper examines the expiration day effects of Taiwan Futures Exchange (TAIFEX) Taiwan Stock Exchange Capitalization Weighted Stock Index (TAIEX) futures (TX), and Singapore Exchange (SGX) Morgan Stanley Capital International (MSCI) Taiwan stock index (MSCI-TW) futures, under different settlement procedures. The results indicate significant price reversal, volatility and abnormal volume stemming from the expiration of the MSCI-TW futures, as compared to the TX, with the expiration day effects becoming much more significant following the adoption of the 5 min closing call procedure by the Taiwan Stock Exchange Corporation (TSEC). The results would seem to support the view that using an average price settlement based on a longer period would mitigate expiration day effects much better than a closing price settlement. © 2006 Elsevier B.V. All rights reserved. JEL classification: G14; G15 Keywords: Expiration day effects; TX; MSCI Taiwan stock index futures

1. Introduction The expiration day effect of derivatives on their underlying securities is frequently accused of being an ‘undesirable’ effect, since two potential sources of the effect are the liquidation of stock positions by arbitragers, and deliberate attempts to manipulate prices. Clearly, from a standpoint of trading mechanism design for derivatives markets, the best form of settlement procedure would be a procedure which induced the lowest degree of price manipulation. ∗

Corresponding author. Tel.: +886 2 2257 6167x439; fax: +886 2 2253 7240. E-mail address: [email protected] (M.-M. Hseu).

1042-4431/$ – see front matter © 2006 Elsevier B.V. All rights reserved. doi:10.1016/j.intfin.2006.06.004

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Major settlement procedures of index derivatives around the world are based on opening, closing and average prices. Some prior studies have found, in terms of mitigating price volatility on expiration days, a procedure based on the market opening would be superior to the one based on the market close. Chicago Mercantile Exchange, New York Futures Exchange, and Sydney Futures Exchange therefore moved the settlement price of their index derivatives contracts from the close to the open in 1987 and 2002, respectively. Recent empirical studies appear to lend support to the notion that using an average price settlement based on a longer period, rather than a single price, can mitigate expiration effects (Chow et al., 2003; Alkeb¨ack and Hagelin, 2004). Existing studies have generally undertaken an examination of the expiration day effects on a single futures contract, or an examination of the expiration day effects under an event-type analysis. In contrast, this paper considers the expiration day effects of two futures contracts, traded simultaneously, under different settlement procedures, investigating the expiration day effects of Taiwan Futures Exchange (TAIFEX) Taiwan Stock Exchange Capitalization Weighted Stock Index (TAIEX) futures (TX) and Singapore Exchange (SGX) Morgan Stanley Capital International (MSCI) Taiwan stock index (MSCI-TW) futures. These futures are simultaneously traded, with their prices generally having a high degree of correlation; however, the settlement of the contracts relies on different mechanisms. This unique contrast in market mechanisms provides us with an excellent opportunity to directly compare the extent of market quality between two competing futures contracts.1 Our analysis also covers the largest component stock on the index, since price manipulation may be more evident in the prices of such stocks, and since such price movement can in turn, have considerable impacts on the index. Indeed, Vipul (2005) pointed to the importance of analyzing the expiration day effects of individual stocks with the highest index weights, because of the relatively large number of arbitrage positions in these stocks. Further analysis of the expiration day effects is therefore undertaken in this study by examining the component stock with the highest weight, Taiwan Semiconductor Manufacturing Corporation (TSMC).2 Our empirical results, based on intra-day analyses, raise a number of interesting issues; for example, given the different settlement methods between the TAIFEX and SGX, the analysis of the expiration day effects for both markets should be particularly informative in terms of guiding the mechanism design for the emerging derivatives markets. The results reveal that the expiration day effects on the TAIEX market stem mainly from the MSCI-TW futures, with these effects having become more significant after the adoption of the 5 min closing call procedure in the Taiwan stock market. This supports the argument of Comerton-Forde and Rydge (2006a) that manipulation has a significant impact on the ‘black box’ of the call auction mechanism.3 The evidence therefore appears to support the view that using an average price settlement rather than a closing price settlement can mitigate expiration effects. 1 Of those studies which have previously engaged in such a comparison of these two markets, there has generally been a focus on price discovery or information transmission between these markets. Cross-border competition in price discovery between the TAIFEX- and SGX-listed contracts has previously been examined by Roope and Zurbruegg (2002), Chou and Lee (2002), Chen et al. (2002) and Hsieh (2004). 2 TSMC is the world’s largest dedicated semiconductor foundry, and is also the largest weighted component stock in the TSEC Taiwan Technology Index, with a share of 27.75%, according to a report released by the TSEC on 10 June 2005. 3 The order book is completely closed to traders during the last 5 min closing call period. Madhavan and Panchapagesan (2000) characterized the unclear process by which investors’ latent demands are translated into prices and volumes as a ‘black box’. Comerton-Forde and Rydge (2006a) found that manipulators may be prepared to use significant resources to inflate stock prices, and thereby create significant impact on call auction prices; thus, arguing that the design of the call auction algorithm is important.

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The remainder of this paper is organized as follows. Section 2 presents the related issues on expiration day effects, and Section 3 describes the data used in this study, followed, in Section 4, by an explanation of the methodology and empirical results. Finally, the conclusions drawn from this study are presented in Section 5. 2. Related issues on expiration day effects The prior studies on expiration day effects have tended to focus mainly on the investigation of possible changes in mean return, volatility, trading volume and price reversal in the underlying securities markets at and around expiration under various settlement procedures.4 As regards closing settlement, some studies found the existence of abnormal returns with greater volatility (Arag´o and Fern´andez, 2002), or abnormal trading volume (Stoll and Whaley, 1997; Corredor et al., 2001; Vipul, 2005) on the underlying index around the expiration day, or evidence of price reversal (Stoll and Whaley, 1997) following the expiration of related index futures. Corredor et al. (2001) and Kan (2001), on the other hand, found there was no evidence of any significant expiration effects on the underlying asset on the expiration day. As regards opening settlement, some studies have reported that, at the expiration day, there was a significant increase in trading volume (Karolyi, 1996; Schlag, 1996) or volatility (Chen et al., 1999), or that after the expiration day, there were return reversals (Schlag, 1996). Following the suggestion of the US Securities and Exchange Commission (SEC) that opening procedures were superior to closing procedures in mitigating expiration day effects, on 19 June 1987, the CME and the NYFE altered the settlement procedures for their index derivatives contracts from the close to the opening of trading.5 This particular reform subsequently attracted a considerable number of studies examining the expiration day effects before and after the change. For example, Lee and Mathur (1999) found that change in the settlement procedure had been successful in reducing volatility on both the NYSE and S&P 500 stock index markets. Recent studies have found that the use of an average price settlement may hinder deliberate price manipulation by speculators, thereby effectively reducing the expiration day effect. Although Chow et al. (2003) found that both the price effect and volatility on the underlying stock market were negative; there was no evidence of any abnormal trading volume on the expiration day, or of any price reversal after the expiration day for HSI derivatives. Examining index derivatives expiration day effects on the Swedish market, Alkeb¨ack and Hagelin (2004) found that trading volume on the cash market was significantly higher on expiration days than on normal days, but that no price distortions existed. They did, however, point out that their results were attributable to the longer settlement period on the Swedish market. In contrast to the prior studies on expiration day effects – where the main focus has tended to be on the impact both before and after the changes in the settlement procedures of a single

4 Examples of the final settlement prices for futures based on the prices of the underlying index stocks at the opening are provided by Standard & Poor’s 500 (S&P 500), Nikkei 225, and Deutscher Aktien Index (DAX) futures. In the Sydney Futures Exchange, the All Ordinaries Share Price Index (SPI) moved the settlement price of its Share Price Index (SPI 200TM ) futures contracts from the close to the open on 18 March 2002. There are also examples of an average price of the index over a short period of time, including the Financial Times Stock Exchange 100 (FTSE 100), the CAC-40 in France, the Hang Seng Index (HSI) and the Swedish OMX index derivatives. 5 At the close, significant sales of stocks can put price pressure on these stocks because of insufficient time remaining to find the other side of the trade. At the opening, however, it is much easier to postpone the sale of stocks until the other side of the trade can be found.

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futures contact – this study considers the expiration day effects of two simultaneously traded index futures. Since this research design minimizes the possible effects of changes in market conditions, we believe the results will be more informative in terms of providing an understanding of the effects of different final settlement procedures on the expiration day effects. 3. Institutional setting and data TAIEX futures contracts, traded under the ticker symbol of TX, were introduced by the TAIFEX on 21 July 1998. These contracts have a monthly expiration cycle, with the last trading day on the third Wednesday of the contract month. Investors with an open position must settle their position in cash based on the price difference between the last settlement price and the settlement price of the last trading day on the settlement day, i.e., the first business day after the last trading day.6 As a result of the intervention of the National Stabilization Fund (NSF) into the futures market, higher price volatility was experienced in the underlying stock market at the opening of each of the expiration days, during the period from October to November 2000. The closing price of the last trading day of October 2000 was 5432.23, while on the last trading day in November 2000 the closing price was 5737.02; however, the respective opening prices on the settlement days of these 2 months were 5261.94 and 5554. There was, therefore, a sharp decline in the opening return for these 2 months; −3.14% for October, and −3.19% for November. As a result, to mitigate the impact of the expiration day effect, on 15 October 2001, the TAIFEX changed the settlement price of the TX contracts from the opening, to the average price of the component stocks of the index within the first 15 min after the opening on the settlement day. The MSCI Taiwan index comprises of the underlying assets of the SGX MSCI-TW futures, based on a market capitalization index of 100 stocks traded on the TSEC,7 with the index representing about 70% of the underlying market. As noted by Hsieh (2004), the return correlations of the TAIEX and MSCI Taiwan index are above 97%. The index provides foreign investors with an opportunity to hedge their Taiwan stock positions, or to arbitrage their index futures positions. As noted by Pagano and Schwartz (2003), trading in derivatives was adversely affected by the ease with which only a few, relatively small orders could change the closing prices in the equity market. In a continuous-trading system, it is difficult for traders to unwind their positions at appropriate prices, and for positions to be marked to market at appropriate prices, at the close. However, in closing call trading, the accumulation of buying and selling orders for each stock for simultaneous execution in a multilateral, batched trade, at a single price, and at a predetermined time, could greatly improve the quality of the closing price. Madhavan (1992) also suggested that, with regard to determining prices during times of market stress, a call auction was much more efficient than a continuous auction. Thus, to mitigate the impact on the MSCI-TW futures at the close of the TAIEX on the expiration day, the TSEC altered the closing price procedure from a continuous-trading mechanism to a 5 min call trading mechanism on 1 July 2002. 6 Whaley (2003) argued that the prices of the underlying assets of cash-settled derivatives were more likely to display expiration effects. 7 The MSCI Taiwan index was initially based on a market capitalization index of 77 component stocks traded on the TSEC. This was increased to a total of 100 stocks from 15 June 2005.

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The different settlement procedures of these two, otherwise similar contracts, provides us with an opportunity to conduct a comparative analysis of expiration day effects.8 This study therefore examines price and volume behavior of TAIEX and TSMC for all expiration days of the TX and the MSCI-TW futures, over the period from September 1998 to December 2004. Our analysis employs intra-day trading data on the TAIEX and TSMC obtained from the Taiwan Economic Journal (TEJ) databank. The observations on the 76 expiration days of the TX and the MSCI-TW futures are collected from the TAIFEX and the Bloomberg trading system. The entire sample period was divided into two in order to facilitate an evaluation of the regulatory changes in the settlement procedures. The pre-change period for the TX runs from September 1998 to September 2001, while the pre-change period for the MSCI-TW futures runs from September 1998 to June 2002. The post-change period for the TX futures runs from October 2001 to December 2004, and for the MSCI-TW futures, the post-change period runs from July 2002 to December 2004. 4. Methodology and empirical results 4.1. Price effects We first investigate whether there were any differences in the expected returns and return volatility between expiration and comparison days (non-expiration days), and then go on to examine the degree of price reversal.9 4.1.1. Abnormal returns If there was discernible price pressure on the expiration day of the index derivatives resulting from the activities of arbitragers or speculators, the underlying stock market would show higher or lower abnormal price movements on expiration days (ARe ) than on comparison days (ARc ). Furthermore, it should also be noted that the settlement price of the TX is based either on the opening price (prior to the reform), or on an average price in the first 15 min of trading (after the reform), while the price of the MSCI-TW futures is based on the closing price for the entire study period. As has been noted in many of the prior studies on stock market microstructure, intra-day patterns of return and trading volume tend to follow a U-shape. Therefore, in similar fashion to Chow et al. (2003), with the exception of all 5 min mean returns on the trading day, the mean return of trading on expiration days (T) for the first half-hour (last half-hour) in the TX (MSCI-TW futures), are, respectively, compared with those on comparison days, which are the trading day immediately before (T − 1) and after (T + 1) the expiration day.10 8 The denomination of the MSCI-TW futures contracts is in US dollars, which differs from the currency of the underlying shares. As noted by Board and Sutcliffe (1996), the currency difference makes it impossible to perform risk-free arbitrage between the futures and the underlying portfolio; however, arbitrageurs who are willing to bear the exchange risk can still trade on the mispricing of the SGX contract, as long as the size of the mispricing justifies the risk. We believe that the exchange risk does not prohibit arbitrage transactions using the MSCI-TW futures. As a result, the impact of exchange risk on the expiration effect should be insignificant. We thank Professor Wen-Liang Gideon Hsieh for proposing this argument. 9 Because the settlement day is the business day following the last day of trading for the TX, we define the settlement day as the expiration day for the TX. 10 For the last half-hour of trading on 76 expiration days for the MSCI-TW futures, the maximum negative price spread on the TAIEX was −102.91, which, from its high of 8223.80 at 11:30 a.m., plummeted to just 8120.89 at the close on 29 June 2000. The maximum positive price spread on the TAIEX was 102.01, and indeed, the TAIEX did see such an increase on 30 January 2001, from 5690.49 at 1:00 p.m., to 5792.50 at the close.

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Both pooled and matched-pair t-tests are used to examine whether the mean return on the expiration day is the same as the mean returns for the comparison days. The average rates of return for the expiration days and the comparison days in month i are defined as: Nc,i

Ne,i

ARe,i

1  = ri,t , Ne,i t=1

ARc,i

1  ri,t = Nc,i t=1

where Ne,i and Nc,i are the respective number of 5 min intervals on the TAIEX on the expiration day and the comparison day. Therefore, the mean returns of the expiration day and comparison day over the sample period are defined as: N

ARe =

e 1  ARe,i , Ne

i=1

N

ARc =

c 1  ARc,i . Nc

i=1

were Ne and Nc are the number of months in the sample period with expiration days and comparison days. The null hypothesis of the pooled t-test is: H0 : ARe = ARc . The mean of the difference between the paired observations is ARe,i − ARc,i , so the null hypothesis of the matched-pair t-test is then defined as: H0 : ARe,i − ARc,i = 0 The results of the pooled and matched-pair t-tests for price effects in both the full sample and the sub-samples are presented in Table 1. The differences in the mean returns between expiration (ARe ) and comparison days (ARc ), using all 5 min returns on the trading day, are reported in Panel A, while the 5 min return differences in the first half-hour and last half-hour of trading, are reported in Panel B and C, respectively. The results of Table 1 indicate that there is no strong evidence to suggest that the expiration day has any association with abnormal returns, although most of the mean returns on the expiration day are higher than those of the comparison days, especially in the case of TSMC. 4.1.2. Return volatility We use a pooled F-test to investigate whether expiration day returns are associated with a higher volatility than that of the comparison period. Our analysis includes data for the whole day, the first half-hour of trading, and the last half-hour of trading. We use F-statistic to test the null hypothesis H0 : σe2 ≤ σc2 ; where σe2 and σc2 are the respective variances in returns during the expiration and comparison periods. The results of the pooled F-test for the volatility effects for the period from September 1998 to December 2004 are presented in Table 2, with the columns reporting the volatility of returns (measured by standard deviation) for the expiration days, one trading day before the expiration day (T − 1), and one trading day after (T + 1). For the MSCI-TW futures, using the 5 min returns in the last half-hour of trading (Panel C), we find that volatility is the only factor which is significantly higher on the expiration day than on the comparison days. On expiration days during the pre-July 2002 period, for example, the volatility of returns was 0.1128%; this was much greater than the volatility of returns one trading day after the expiration day (0.0679%; F-statistic = (0.11282 /0.06792 ) = 2.76) at the 1% significance level, but less than the volatility of returns one trading day before the expiration day (0.1186%; F-statistic < 1.00). In the case of the TAIEX there is a discernible shift in the volatility effect from (T + 1) pre-July 2002, to (T − 1) post-July 2002. In the case of TSMC, for the pre-reform period, we find that the volatility on expiration days is not significantly higher than the volatility 1 day prior to the

Period

TX

Period

T vs. T − 1 Returns diff.

Pooled Matched -pair Returns t-statistic t-statistic diff.

Panel A: all 5 min returns for the trading day September 1998– 0.0001 0.01 0.01 December 2004 Pre-October 2001 −0.0015 −0.12 −0.17 Post-October 2001 0.0015 0.23 0.21 Panel B: 5 min returns for the first half-hour of trading September 1998–December 2004 TAIEXb −0.0369 −1.12 −1.22 TSMCc 0.0427 1.64 1.60

MSCI-TW Futures T vs. T − 1

T vs. T + 1 Pooled Matched -pair t-statistic t-statistic

T vs. T + 1

Returns diff.

Pooled Matched-pair t-statistic t-statistic

Returns diff.

Pooled Matched-pair t-statistic t-statistic

0.0050

0.84

0.84

−0.0028

−0.51

0.51

0.0055 0.0041

0.62 0.64

0.61 0.67

−0.0041 −0.0007

−0.51 −0.12

−0.52 −0.11

0.0070 0.0068

0.50 0.26

0.44 0.27

0.0005

0.08

0.07

−0.0009 0.0018

−0.08 0.33

−0.07 0.31

September 1998– December 2004 Pre-July 2002 Post-July 2002

Panel C: 5 min returns for the last half-hour of trading September 1998–December 2004 TAIEX 0.0293 1.83 1.57 TSMC 0.0271 1.01 0.97

−0.0216 0.0317

−0.65 1.14

−0.68 1.22

Pre-October 2001 TAIEX −0.0345 TSMC 0.0600

−0.62 1.56

−0.75 1.46

−0.0356 0.0020

−0.62 0.05

−0.66 0.05

Pre-July 2002 TAIEX TSMC

0.0269 0.0335

1.12 0.93

0.93 0.88

0.0107 0.0099

0.55 0.30

0.47 0.29

Post-October 2001 TAIEX −0.0393 TSMC 0.0263

−1.08 0.75

−0.98 0.76

−0.0084 0.0599

−0.23 1.68

−0.24 1.66

Post-July 2002 TAIEX TSMC

0.0329 0.0172

1.97 0.43

1.98 0.42

0.0013 0.0019

0.07 0.04

0.06 0.05

a All returns difference (returns diff.) expressed in percentages. b TAIEX denotes the Taiwan Stock Exchange Capitalization Weighted Stock Index. c TSMC denotes the individual stocks of the Taiwan Semiconductor Manufacturing Corporation.

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Table 1 Pooled and matched-pair t-test for the price effecta

113

114

Table 2 Pooled F-tests for the return volatility effecta TXb T Returns volatility

Period T−1 Returns volatility

T vs. T − 1 T + 1 Pooled Returns F-statistic volatility

Panel A: all 5–min returns volatility for the trading day September 1998– 0.0422 0.0432 <1.00 0.0373 December 2004 Pre-October 2001 0.0558 0.0514 1.18 0.0469 Post-October 0.0235 0.0342 <1.00 0.0257 2001 Panel B: 5 min returns volatility for the first half-hour of trading September 1998–December 2004 TAIEX 0.2074 0.1974 1.10 0.2056 TSMC 0.1733 0.1459 1.41 0.1692 Pre-October 2001 TAIEX TSMC

T Returns volatility

T−1 Returns volatility

T vs. T − 1 T + 1 Pooled Returns F-statistic volatility

T vs. T + 1 Pooled F-statistic

0.0357

0.0378

<1.00

0.0319

1.25

0.0424 0.0224

0.0433 0.0277

<1.00 <1.00

0.0347 0.0275

1.49 <1.00

Panel C: 5 min returns volatility for the last half-hour of trading September 1998–December 2004 TAIEX 0.1004 0.0966 1.08 0.0708 TSMC 0.1820 0.1460 1.55 0.1388

2.01** 1.72*

T vs. T + 1 Pooled F-statistic 1.28 1.41 <1.00

1.02 1.05

MSCI-TW Futuresb

September 1998– December 2004 Pre-July 2002 Post-July 2002

0.2629 0.1698

0.2167 0.1604

1.47 1.12

0.2308 0.200

1.30 <1.00

Pre-July 2002 TAIEX TSMC

0.1128 0.1778

0.1186 0.1667

Post-October 2001 TAIEX 0.1382 TSMC 0.1782

0.1789 0.1274

<1.00 1.96

0.1816 0.1337

<1.00 1.78

Post-July 2002 TAIEX TSMC

0.0791 0.1892

0.0461 0.1084

a b * **

All returns volatilities (measured by standard deviation) are expressed in percentages. The pooled F-statistics are recorded as <1.00 when the volatility on the expiration day is less than that of the comparison day. The test statistics are significant at the 5% level. The test statistics are significant at the 1% level.

<1.00 1.14 2.95** 3.05**

0.0679 0.1409

2.76** 1.59

0.0762 0.1360

1.08 1.93

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expiration day (T − 1). However, in the post-reform period, the volatility on expiration days was significantly higher than the volatility 1 day before the expiration day (T − 1). This implies that the move to closing call trading was unable to effectively eradicate the expiration day effects. Panel C of Table 2 also shows that the TAIEX has greater volatility on the expiration days of the MSCI-TW futures, relative to the day before expiration days (F-statistic = 2.95), with TSMC demonstrating significant volatility during the post-reform period. This supports the argument that the component stock with the highest weight will play an important role in volatility on the TAIEX. 4.1.3. Price reversals If the proposition is true – that the unwinding of index arbitrage stock positions, or price manipulation at expiration, purportedly (and temporarily) drives up stock prices out of equilibrium – the underlying stocks prices should rebound in the opposite direction after the expiration of the index future (Stoll and Whaley, 1991). Since the opening price of the TAIEX on the settlement day was used as the final settlement price of the TX prior to 15 October 2001, we first define the opening TAIEX and TSMC returns, Rb1 , as well as the returns after the opening on the expiration day for TAIEX futures, prior to the reform, Rb2 , as: Rb1 =

Popen,t − Pclose,t−1 Pclose,t−1

(1)

Rb2 =

Pclose,t − Popen,t Popen,t

(2)

where Popen,t and Pclose,t are the respective opening and closing prices of the TAIEX or TSMC on the settlement day for the TX, and Pclose,t−1 is the closing price of the TAIEX or TSMC on the last trading day. The return reversal measure prior to the reform, REVb,TX , is then defined as:  Rb2 , if Rb1 < 0 REVb,TX = (3) −Rb2 , if Rb1 ≥ 0 A positive value for REVb,TX indicates a return reversal, while a negative value indicates a continuation. The settlement price for the TX contracts was changed on 15 October 2001, from the opening on the settlement clearing day, to the average price within the first 15 min after the opening; we therefore define a new measure of the return reversal after the regulatory change on the settlement price as follows: Ra1 =

Popen+15,t − Pclose,t−1 Pclose,t−1

Pclose,t − Popen+15,t Popen+15,t  Ra2 , if Ra1 < 0  REVa,TX = −Ra2 , if Ra1 ≥ 0 Ra2 =

(4) (5)

(6)

where Ra1 is the first 15 min TAIEX or TSMC return on the settlement day, and Ra2 is the return after the first 15 min on the settlement day for the period after the reform. A positive value

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for REVa,TX indicates a return reversal after the reform, whereas a negative value indicates a continuation. As regards the MSCI-TW futures, following the revision of the closing price procedure by the TSEC on 1 July 2002, from continuous auction to the last 5 min call auction, a measure of the return reversal is defined as: R1 =

Pclose,t − Pclose−1p,t Pclose−1p,t

Popen,t+1 − Pclose,t Pclose,t  R2 , if R1 < 0 REVMSCI = −R2 , if R1 ≥ 0 R2 =

(7) (8)

(9)

where R1 is the last trading index or individual stock return on expiration day; R2 is the return from the close to the opening of the next trading day after expiration day; Pclose−1p,t is the last price before the close on expiration day11 ; Pclose,t is the closing price on expiration day; and Popen,t+1 is the opening price of the next trading day after expiration day. A positive value for REVMSCI would indicate a return reversal for the index, or individual stock, on the expiration day of the MSCI-TW futures, whereas a negative value would indicate a continuation. We employ a binomial test to examine the expiration day effect on the TAIEX, or TSMC, with the null hypothesis that price reversal occurs ‘randomly’, i.e., less than, or equal to, 50% of the time. Table 3 reports the mean price reversals for both the TAIEX and TSMC on the monthly expiration days of the TX and MSCI-TW futures over the period from September 1998 to December 2004. Of the overall sample of 76 expiration days, there were 42 price reversals on expiration days for the TX, and 38 price reversals on expiration days for the MSCI-TW futures. Although there was an increase in post-reform mean reversals, most of the increases in the various sample periods were not significant. As regards the frequency of TAIEX price reversals on expiration days, the only p-value which was significantly different from 0.5 (at the 5% significance level) was the value for the MSCI-TW futures (0.014) in the post-reform period. It is worth noting that the mean reversal for the TSMC stocks (1.8777% for the expiration days of the TX, and 1.6240% for the expiration days of the MSCI-TW futures) was higher than the mean reversal for the TAIEX (1.2235% for the expiration days of the TX, and 0.5136% for the expiration days of the MSCI-TW futures). This evidence suggests that, to earn more money, institutional investors may resort to manipulating the price of the cash index by pulling up or pushing down the price of the component stock with the highest weight by taking advantage of the fact that the order book is completely closed to traders during the last 5 min closing call period. The evidence also supports the argument of Comerton-Forde and Rydge (2006a), that manipulation has a significant impact on call auction prices. The results of Tables 1–3 suggest that the change in the closing settlement procedure of the MSCI-TW futures, from continuous auction to 5 min call auction, has not been particularly

11 The last price before the close for the TAIEX is as follows: from 1 September 1998 to 30 April 1999 it was the index at 11:55 a.m.; from 1 May 1999 to 31 December 2000, it was the index at 11:59 a.m.; from 1 January 2001 to 30 June 2002, it was the index at 1:29 p.m.; and after 1 July 2002, it was the index at 1:25 p.m.

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Table 3 Mean price reversal effect Period

No. of expiration days

Price reversal Maximum (%)

Minimum (%)

Mean (%)

No. of observations

p-Valuea

3.4462 4.3860

0.0076 0.5208

1.2235 1.8777

42 33

(0.179) (0.874)

Pre-October 2001 TAIEX 37 TSMC 37

2.4812 3.1746

0.0076 0.7273

1.0145 2.0540

20 12

(0.311) (0.984)

Post-October 2001 TAIEX 39 TSMC 39

3.4462 4.3860

0.0461 0.5208

1.4135 1.7770

22 21

(0.212) (0.315)

1.4674 5.5215

0.0316 0.3509

0.5136 1.6240

38 33

(0.500) (0.874)

Pre-July 2002 TAIEX 46 TSMC 46

1.1802 4.0000

0.0524 0.3509

0.4836 1.6406

17 18

(0.962) (0.930)

Post-July 2002 TAIEX 30 TSMC 30

1.4674 5.5215

0.0316 0.6237

0.5378 1.6042

21 15

(0.014)* (0.500)

TX September 1998–December 2004 TAIEX 76 TSMC 76

MSCI-TW Futures September 1998–December 2004 TAIEX 76 TSMC 76

a *

p-Values are calculated using a binomial distribution. The test statistic is significant at the 5% level.

effective in terms of alleviating the deliberate manipulation of prices by speculators and arbitragers during the last half-hour of trading. 4.2. Volume effects Since index futures contracts are settled in cash, if the number of open positions to be unwound in the cash market was significant, one would expect to observe abnormally high trading volume in the component stocks of the index. Stoll and Whaley (1991), Karolyi (1996) and Chow et al. (2003) all found that abnormal trading volume was discernible on expiration days. To determine whether adjusted trading volume in the stock market differs between expiration days and comparison days, we compare the mean volume on expiration days (denoted as AVe ) with the mean volume on the comparison days (denoted as AVc ). Similar to our analysis of price effect, we examine whether or not there is any volume effect for the first half-hour and last halfhour of trading. The adjusted trading volumes are expressed as mean proportions of monthly average volume, i.e., the total volume divided by the monthly average volume. The differences in the mean proportion of monthly average volume between expiration and comparison days are presented in Table 4, with the columns reporting the differences in the proportion of monthly average volume between the expiration day and two different comparison days. The results show that on the expiration days for the MSCI-TW futures, the trading volumes

118

Period

TX

Period

T vs. T − 1 Volume diff.

T vs. T − 1

T vs. T + 1 Pooled t-statistic

Matched -pair t-statistic

Panel A: adjusted trading volume for the trading day September 1998– 0.0493 1.33 1.75 December 2004 Pre-October 2001 0.0577 1.04 1.40 Post-October 2001 0.0412 0.83 1.06

Volume diff.

Pooled t-statistic

Matched -pair t-statistic

−0.0069

−0.18

−0.24

−0.0184 0.0041

−0.30 0.08

−0.47 0.10

September 1998– December 2004 Pre-July 2002 Post-July 2002

−1.11 0.96

−1.35 1.07

Panel B: adjusted trading volume for the first half-hour of trading September 1998–December 2004 TAIEX 0.0153 1.48 1.77 −0.0137 TSMC 0.0464 1.53 1.54 0.0293

MSCI-TW futuresb T vs. T + 1

Volume diff.

Pooled t-statistic

Matched-pair Volume t-statistic diff.

Pooled t-statistic

Matched-pair t-statistic

−0.0221

−0.55

−0.82

−0.0062

−0.16

−0.23

−0.0319 −0.0071

−0.57 −0.13

−0.84 −0.20

0.0016 −0.0182

0.03 −0.29

0.04 −0.43

Panel C: adjusted trading volume for the last half-hour of trading September 1998–December 2004 0.0095 TAIEX 0.0141 1.78 2.71** TSMC 0.0986 2.95 2.91** 0.0625

1.23 1.86

Pre-October 2001 TAIEX TSMC

0.0207 0.0572

1.25 1.19

1.52 1.26

−0.0216 0.0025

−1.03 0.05

−1.31 0.06

Pre-July 2002 TAIEX TSMC

0.0050 0.0254

0.49 0.54

0.76 0.54

Post-October 2001 TAIEX TSMC

0.0103 0.0363

0.80 0.95

0.93 0.89

−0.0062 0.0541

−0.47 1.43

−0.51 1.50

Post-July 2002 TAIEX TSMC

0.0281 0.2107

2.83** 5.26**

3.60** 5.27**

a No trading data exists for TSMC at 9:30 on 21 September 2001; therefore, the expiration days for September 2001 are excluded. * The test statistics are significant at the 5% level. ** The test statistics are significant at the 1% level.

0.0058 −0.0167 0.0152 0.1840

0.58 −0.36 1.43 4.38**

2.08* 2.04* 1.08 −0.43 1.87 4.35**

H. Chung, M.-M. Hseu / Int. Fin. Markets, Inst. and Money 18 (2008) 107–120

Table 4 Pooled and matched-pair t-test for the volume effecta

H. Chung, M.-M. Hseu / Int. Fin. Markets, Inst. and Money 18 (2008) 107–120

119

of both the TAIEX and TSMC were not significantly higher than those of the comparison days during the last half-hour of trading for the pre-July 2002 period. The volumes were, however, significantly higher than those of the comparison days in the last half-hour of trading during the post-July 2002 period, particularly in the case of TSMC; this is a result which is line with the findings of Vipul (2005).12 In summary, the empirical results suggest the expiration effects became more significant for the MSCI-TW futures after the adoption of a 5 min closing call procedure. As noted by ComertonForde and Rydge (2006b), the matching algorithm and the level of transparency are two of the important features for the design of a call auction. Since the order book is not open to traders during the last 5 min closing call period, the TSEC may wish to consider further attempts at improving overall market transparency during the call auction period. Alternatively, as in the case of the Sydney Futures Exchange, the SGX might consider moving the settlement price of the MSCI-TW futures contract from the close to the opening. 5. Conclusions This study has examined the expiration day effects of the TX and the MSCI-TW futures on the Taiwan stock market using intra-day data covering the period from September 1998 to December 2004. We anticipate that such a comparison of the expiration day effects between the TX and the MSCI-TW futures will be particularly informative, partly because both contracts are traded simultaneously. Furthermore, a comparison of the expiration day effects between these two markets is immune to the effects of changes in market condition, since both contracts are based on the two, almost perfectly correlated, stock indices of Taiwan. The complete sample period was divided into two sub-periods based on the date of the change in the settlement procedures. The evidence indicates that there were no expiration day effects on the TX throughout the whole of the study period, including both sub-periods. Conversely, our findings demonstrate that significant expiration day effects existed amongst the MSCI-TW futures on the Taiwan stock market, with both price and volume distortions becoming more significant as a result of the move from the continuous auction to the 5 min closing call auction procedure. We postulate that the main reason for this is that the 5 min closing call procedure of the TSEC continues to represent a closing settlement procedure based on a single price. As noted by Comerton-Forde and Rydge (2006a,b), and supported by this study, the design of the call auction algorithm is very important, and as such, it is suggested that any call auction design which fails to consider order imbalances will have a direct impact on the efficiency of call auction prices. Acknowledgements We would like to thank an anonymous referee, Wen-Liang Hsieh, Ike Mathur (editor) and the seminar participants at the 18th Australasian Finance and Banking Conference, and National Taiwan Technology University, for their valuable comments. Any remaining errors are our responsibility alone.

12 As reported in the China Times, foreign investors placed large buy orders prior to the close on 5 January 2005 to boost the settlement prices after the MSCI announced that it would raise Taiwanese shares in the MSCI indices to their full weight beginning in November 2004, and ending in May 2005. This activity has attracted the attention of the Financial Supervisory Commission. See: www.chinatimes.com dated 5 January 2005.

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