Thesis Seminar Finance (6314M02343)
Thesis Proposal – First Draft
Chavdar Tsenev, 10840974
Comparative study of abnormal stock performance on announcements of FTSE 100 and FTSE 250 index revisions – is there evidence of inattention for smaller caps?
1. Research Question
Trading strategies that focus on stocks’ inclusion/exclusion in the composition of a major stock exchange index have always been an interesting topic for academic research with high practical application. The highest amount of papers on the subject is focused on the American stock market, and mainly on stock performance in relation to changes in the S&P 500 index constituents.
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The analysis of stock market index constituents has been dominated by two main contradicting financial theories. The price pressure hypothesis, which was first introduced by Scholes (1972), suggests that share prices can deviate from long-run equilibrium and a short-term price increase occurs when there is a positive shift in demand, caused by rebalancing of investors’ portfolios. The temporary effect of this hypothesis is contrasted by the imperfect substitutes hypothesis, devised by Shleifer(1986). It predicts a permanent price effect, caused by inclusion in a stock index, since investors cannot find a perfectly equivalent stock. In his study Shleifer finds that since September 1976 the inclusion of a stock in the S&P 500 index earned investors an additional 3% return on the date the announcement and that the effects persists at least 10 to 20 days after the event. He also established a higher trading volume around the announcement.
A similar study conducted by Harris and Gurel (1986) in the 1973-1983 period found an immediate price increase after an announcement for stock inclusion, followed by a reversal in the following 3 weeks, while at the same time the event is marked by above average trading volume. The above arguments showed support for the Price pressure hypothesis.
Since 1989 changes to the S&P 500 have been announced five days before the effective date of stock exclusion/inclusion in order to overcome previously documented buying pressure from index funds. Beneish and Whaley (1996) report that stocks added to the S&P 500 between 1989 and 1994 exhibit positive abnormal returns between the announcement and effective dates which are afterwards reversed only partially, pointing at the permanent effect of changes in constituents of the S&P 500.
More recent researches in the area include Wurgler and Zhuravskaya (2002) who find support for downward sloping demand curves for stocks included in the S&P 500, since the absence of perfect stock substitutes deters risk-averse arbitrageurs from flattening the demand curve. Chen, Noronha, and Singal (2004) conduct a study on a longer time frame (1961 to 2000) and their most important finding is that the price effect for stock inclusion in the S&P 500 is permanent, whereas the decline for stocks that were removed from an index is only temporary. They explain the fact by arguing that investor awareness for a stock is easily increased by the publicity surrounding inclusion in a major index, but once a stock has already become salient, it is more difficult that it loses market participants’ attention once it is deleted from an index.
A study that focuses on small-cap stocks performance on their inclusion in the Russel 2000 index is performed by Biktimirov, Cowan and Jordan (2004). The criteria for entering the Russel 2000 are based solely on market cap, and the research finds a significant change in price, volume and institutional ownership for stocks entering or...