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• Going beyond size and introducing dimensions of access, efficiency and stability
• New efficiency indicators and their relation to capital market development
Financial Sector Indicators Note: 3 Part of a series illustrating how the Financial Sector Development Indicators (FSDI) project enhances the assessment of financialsectors by expanding the measurement dimensions beyond size to cover access, efficiency and stability. Data on these dimensions,as well as other information relevant for financial sector assessment, is intended to become available online during Spring 2006.
Equity market indicators: A primer
Equity markets are multi-dimensional and
measures to assess their development have togo beyond size—measured usually by the ratioof market capitalization to GDP. For a morecomprehensive overall assessment, the devel-opment of capital markets may be
benchmarked along the four dimensions of theFinancial Sector Development Indicators(FSDI): size (conventionally analyzed), access,
efficiency and stability. For each of thesedimensions, several indicators have beendeveloped (in FSDI) to generate a compositemeasure, as well as facilitate benchmarking.
At an aggregate level, developed, or high-income countries (e.g. USA) perform betterthan developing countries in all four dimensions
of their financial sector (chart, below). However,there are notable differences between the twosets of countries in terms of various dimen-
sions. Some developing country equity marketsare particularly less efficient, such as Pakistan,while in others differences in stability are morepronounced, such as in the Czech Rep. A more
focused identification of weaknesses andstrengths in equity markets, over and above ageneral assessment through FSDI can helpidentify priority areas for policy making in
formulating financial reforms.
Introduced below are select new indicators that
represent dimensions over and above the sizeof an equity market (other similar indicators are
Indicators for equity marke ts
T raditio nal N ew
Size A ccess
M arket capitalization to GDP M arket capitalization of to p 10 firms
Turnover ratio Trading volume of top 10 firms
Stock t raded to GDP Her findahl’ s index o f concent rat ion
Closely held shares in t op 10 firms
Efficiency
Synchronicity / Como vement of sto cks
Detectable private informatio n trading
Liquidity / Transaction co sts
Stability
Volatility
Skewness o f market returns
Vulnerability to earnings manipulatio n
Price earnings ratio
Duration
Efficiency
Stability
Size
Access
Equity market per the financial sector dimensions
Developed
Developing
Note:Axes represent standardized scores for each dimension ofthe capital market.
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being developed for bond markets). The focus isparticularly on the efficiency dimension, due tothe novelty of the information, as well as its
relative lack of familiarity to many users. Thesize and access dimension are discussed onlybriefly, as a detailed discussion is presented in a
separate note (Financial Sector Indicators Note :4).
SizeFSDI enhances the capacity for measuring eventhe commonly assessed size dimension,
beyond the widely utilized ratio of “Market Capi-talization to GDP”, which reflects the value of
existing stock of equity claims. This is achievedby a couple of other flow variables, the ratio of“Value Traded to GDP” and the “Turnover ratio”.
Both these variables measure the capacity of astock market in relation to trading activities,diversification, and liquidity provision function.The graph below shows the turnover ratio in the
regions. The highest turnover is in the NorthAmerica and East Asia and the lowest turnover
is in the Africa region.
Creating composite indicatorsThe composite indicator for each of the various four
dimension of capital markets is comprised of sub-
indicators. These sub-indicators are standardized bysubtracting the median of the distribution and scaled by
the standard deviation of the distribution. Thesestandardized scores are then averaged to create the
composite indicator for each dimension.
Access
The access indicators in FSDI refer primarily to
measures of concentration, as data for it arereliably available for a wide cross-section of
countries. The composite indicator of access isbased on the following three variables:
• Concentration of market capitalization . This is
the share of the top 10 largest firms in the totalmarket capitalization of a stock market. A goodcapital market should give access not only to
the largest firms, but also to smaller ones.• Herfindahl index . This takes into account the
statistical distribution of the market value of
0
2
4
6
8
10
12
4 7 10 13
Access and size
Composite Access Indicator
Composite Size Indicator
USA
UK
Russia
SloveniaBrazil
0 20 40 60 80 100
Turnover ratio by region, 2004
South Asia
North
East Asia
Europe & .
C.Asia
Mid East &
N. Africa
Latin
America
Sub-Sah.
Africa
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stocks outside the top 10 firms. This measureis quite meaningful, but less naturally interpret-
able than the previous one.• Percentage of closely-held shares . As mea-
sured by the percent of shares in the hands ofcontrolling majority. This indicator has two fold
implications on access from the perspective ofoutside investors. First when shares areconcentrated in the hands of the insiders,relatively few shares will be available to outside
investors. Also concentrated ownership cre-ates barriers for outside investors to monitor
firm’s operations.
The composite access indicator suggests thatlarger stock markets in general give access to abroader and more diverse set of firms, as exem-
plified by the case of the United States, but evensome smaller markets, such as Slovenia, arealso well able to list smaller firms as shown inthe graph (chart right, previous page).
Efficiency
A capital market’s efficiency can bebenchmarked against other markets by con-
structing a composite efficiency indicator basedon the average of three indicators listed below.
These indicators are constructed by compilingand statistically processing firm level data from
a variety of market sources:
• Price synchronicity . This indicator capturesthe information content of daily stock prices,
as a market operates efficiently only whenprices are informative about performance ofindividual firms.
• Private information trading . Based on the
examination of daily price-volume patterns,this variable helps indicate the prevalence of
trading in a stock market based on private orprivileged information.
• Real transaction cost . This is based on dailyreturn data of the listed stocks. The estimateof this information is important for determin-
ing the barriers to efficiency in an equity stockmarket.
Composite Efficiency Indicator Based on the composite indicator of overallefficiency, it is revealed that some countries,
such as Pakistan, have large but inefficientequity markets, while many small equity mar-kets, such as Austria, are able to display highefficiency (chart, below). The table belowpresents select country rankings on the com-
0
1
2
3
4
5
6
7
8
4 6 8 10 12
Efficiency and size
Composite Efficiency Indicator
Composite Size Indicator
Pakistan
Austria
Brazil 35
China 51
France 15Germany 11
India 46
Japan 29
Korea 16
Russia 32
USA 6
Select rankings for market efficiency
Note: Higher ranking indicates lower efficiency.
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posite efficiency indicator. We next discuss thethree indicators.
R 2 - Measure of Synchronicity
This indicator captures the co-movement ofindividual stock returns in an equity market. Highlevels of co-movement (or synchronicity) indi-cate that returns on individual stocks do not
provide much firm-specific information. In anefficient equity market, stock prices shouldreflect primarily information about the fundamen-
tals of corporations. The highest co-movement
is among developing countries like China andIndia (chart below, left).
In scenarios where rights of minority sharehold-ers are weak, the controlling owners or theentrenched management are usually not pres-
sured to share their private information about thecorporation with outsiders. High synchronicitycan sometimes be the outcome of corporationsnot reporting timely and reliable information
about their real performance. Thus, little useful
information is available to the public, and specificcorporate information is not reflected in stockprices in an efficient way. Under such circum-
stances, outside small investors usually tradebased on rumors and sentiments, and stock
prices of individual firms become influencedpredominantly by the general market sentiment.
Private Information Trading
This measure captures the percentage of firmswith trading patterns that arise from tradingconducted through privately obtained informa-
tion. Investors with privileged information cancarry out trades before investors lacking suchinformation, thus giving rise to a correlation instock returns over several successive days
(autocorrelation). Such trading with private
information is presumably more prevalent whencorporations are opaque in their information
dissemination and corporate governance is
5 10 15 20 25 30 35
Japan
UK
Israel
Pakistan
Portugal
Bulgaria
Trading on private Information, 2004 (higher is worse)
An example of private information trading
When an investor privately receives a piece of good
news about a firm, he will buy the stock before the newsbecome public the day after. The purchase creates
abnormal trading volumes and pushes up the price. Onthe next day, when the news is available to the public, the
stock price drifts up further towards the newly estab-lished price of the corporation, with good news incorpo-rated. Thus, abnormal trading volumes are observed on
the first day and autocorrelation of stock prices between
the first and the second day.
5 10 15 20 25 30 35 40 45
Germany
France
UK
Canada
USA
Thailand
Argentina
Greece
India
China
Developed
Developing
Synchronicity in stock prices, 2004 (higher is worse)
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weak. In contrast, transfer of information to thegeneral public is usually prompt and accuratewhen corporations make timely and reliable
disclosures, leaving little chance of privilegedinformation for few insiders. Data on Bulgaria,Portugal and Pakistan suggest that 25%-35%
of the firms listed on their stock exchanges lendthemselves to price-volume patterns that maydepict trading based on private information. Incomparison, in Israel, United Kingdom and
Japan less than 10% of the listed firms exhibitsuch a pattern (right chart, previous page).
Transaction Costs/Liquidity For the purposes of this indicator, transactioncosts are broadly defined—implicitly taking into
account the potential impact on stock pricesdue to large trades, information asymmetry anddirect costs such as fees etc. Informationcontained in daily stock price movements is
exploited to implicitly derive transaction costassociated with trading a particular security. A
comparison of trading days when market pricesdo not move (zero return or stale trading days)
is made against days when prices do move(active trading days).
Stale trading days generally result when trans-action costs of trading exceeds the gainsavailable to an informed trader. Trades will onlyoccur when investor gains exceed the transac-
tion cost in a particular security. A security withhigh transaction costs will have less frequentprice movements, i.e., more zero returns than
a security with low transaction costs. An illiquidcapital market with high transaction cost will beineffective in monitoring the performance ofindividual firms, because new information
cannot be incorporated into stock prices effi-ciently and promptly. The causes of illiquiditycan be transaction costs, but equally as wellinformation asymmetries that make outsiders
reluctant to trade with insiders.
Low Cost High Cost
Czech Republic Sri Lanka
China Cyprus
USA Slovakia
Mexico Philippines
Italy Venezuela
Ranking of Countries by Transaction Costs
StabilityThe composite indicator measuring stability is
based on indicators that go beyond traditionalmeasure of market stability, such as volatility instock price or returns. The stability measuresare based on total market returns and attempt to
capture systematic risk. The composite indicatorfor market stability highlights interesting results,such as less stable markets are usually smaller(
e.g . Venezuela), however, this correlation is farfrom perfect, for example Korea has a large but
Opaque stocks and higher skewness
There is evidence that high opacity of a corporation, asmeasured by high synchronicity of its stock returns with
the market, is usually associated with less stability. The
reason is that, the management has a greater incentiveto hide bad news than to hide good news. Good news is
always released to the public promptly after it arrives,and the public adjusts the stock price accordingly, which
creates more gradual upward price adjustments. Bad
news, however, is usually accumulated and covered upby the management, particularly when corporate gover-
nance is weak. Bad news eventually comes out thoughwhen the management finds it impossible to hide it for-
ever. As a result, bad news is usually released in a batchand creates abrupt and large negative impact on the stock
price. Furthermore, the public inevitably feels that the cor-poration is still hiding something, and overreacts to thebad news. As a result, the firm’s stock returns become
skewed to the negative side, i.e., the stock may deliverlarge negative returns concentrated over several days.
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less stable market (top chart, where lowerscores are less stable).
The new measures of stability, mentioned below,are incorporated in the composite indicator,particularly take into account negative returns.
• Measure of skewness . A market with a morenegatively skewed distribution of stock returnsis likely to deliver large negative returns, andmay be prone to less stability. Distribution
skewness is an ex-post and market-wideindicator based on a previous history of largenegative returns.
1
40
1 40
Accounting practices and stock markets, 2003
Stock market synchronicity, annual ranking [1=best]
Earnings management, annual ranking [1=best]
Sample: 40 countries
• Vulnerability to earnings manipulation . Thisindicator is derived from certain characteris-tics of information reported in the balance
sheet and income statements of companies,which can be indicative of manipulation ofearnings. It highlights the percentage of firms
listed on a stock exchange that are suscep-tible to such earnings manipulation. Firmsscoring higher in this indicator are expected tobe more likely to experience reinstatement of
incomes in the future, and may thus end updelivering large negative returns. Unlike the
skewness measure, this is an ex-ante andfirm-specific measure of stability.
Using the indicator for earnings manipulation,interesting comparisons and benchmarking can
be conducted. In Zimbabwe, almost all firmsmay experience high manipulation of theiraccounting statements, while in Turkey, thenumber is nearly 40 percent. This stands in
sharp comparison to high-income markets suchas in France, United States and Belgium, where
less than 10% of firms have issues concerningearnings manipulation, and their markets are
less vulnerable to instability (chart below, left).
0
1
2
3
4
5
6
7
8
4 6 8 10 12
Stability and sizeComposite stability indicator
Composite Size Indicator
Venezuela
Switzerland
USA
Argentina
Korea
0 20 40 60 80 100
BELGIUM
USA
FRANCE
HONG KONG
SINGAPORE
TURKEY
ZIMBABWE
Earnings manipulation probability, 2004 (higher is worse)
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Availability of information through the FSDI Web site
Data on traditional, as well as new indicators for
assessment of capital markets will become availablethrough the FSDI interactive Web site, currently under
construction. Such indicators, along with various othervariables, would form part of an overall framework for
assessing financial sectors that would be availableonline. Provision of regional and country details in the
Web site will offer users the flexibility of customizing
information to their unique requirements.
The other two indicators are based on the factthat market prices contain expectations of futurecash flows and growth instead of current funda-
mentals only, and therefore stock prices may bemore volatile and negatively skewed in thefuture. The indicators available for measuring
this behavior are:• Price earnings (P/E) ratio . A high P/E ratio
means that stock prices contain expectationabout earnings growth.
• Duration . This indicator is a refined version ofP/E ratio, which takes into account factors
such as long term growth, interest rates, etc.
Benefits of enhanced informationThe size, access, efficiency and stability indica-tors introduced provide a comprehensive,
multidimensional framework that is also possibleto implement in order to assess the develop-ment of equity markets. Such a framework canbenchmark stock markets across countries,
regions, and identify the relative strengths andweaknesses across various dimensions. Analy-
ses through comprehensive information can notonly assist in policy formulation, but also provide
a mechanism to evaluate the impact of thereforms. In addition, benchmarking tools canprovide incentives for reforms and facilitate
collection of reliable data that can help increasetransparency in financial systems.
Select References
Bae, K. H, C. Lin and J. Wei, 2005, “Corporate Gover-
nance and Conditional Skewness in the World’s StockMarkets.”Journal of Business forthcoming.
Jin, Li and Myers, Stewart C., 2005 “R-Squared Aroundthe World: New Theory and New Tests”, Journal of
Financial Economics forthcoming
Morck, R B Yeung and W. Yu., 2000.,” The InformationContent of Stock Markets: Why Do Emerging Markets
Have Synchronous Stock Price Movements?” Journal of Financial Economics 58(1) 215-260.
Lesmond, D., C.Trzcinka and J. Ogden.,1999.,”A New
Estimate of Transaction Costs”, Review of Financial
Studies , Volume 12, Number 5, Winter 1999, 1113-1142.Lesmond, D.,,2005.,”Liquidity of Emerging Markets”,Journal of Financial Economics forthcoming.
Llorente G., R Michaely, G Saar, J Wang, 2002,” DynamicVolume-Return Relation of Individual Stocks, Review of
Financial Studies, Vol 15, No.4, 1005-1047
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