The Behavior of Secondary European Stock Markets to Positive and Negative Shocks

ABSTRACT This paper tests the Efficient Market, the Overreaction and Uncertain Information Hypotheses for small European stock exchanges. Previous articles have associated inefficiencies generated by thin markets with investor overreaction, thereby refuting the Efficient Market Hypothesis. However, the arrival of new information introduces a period of increased risk and uncertainty to the rational agents. Hence, the Uncertain Information Hypothesis is a variation of the efficiency theory, accounting for investor reactions to unexpected surprises. The evidence suggests that small European stock markets exhibit a great degree of efficiency following unexpected disruptions. Institutional and legislative arrangements can explain the exceptions. JEL: C3, D8, F3, F4, G0, Gl, L8, 05, 052. Keywords: Financial Market Efficiency; Europe; Overreaction and Uncertain Information Hypotheses; Belgium, Denmark, Finland, Greece, Ireland, Luxembourg, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and Turkey; World Stock Index I. INTRODUCTION Financial agents interact with each other in a rational and efficient manner. A competitive environment, such as the one governing financial markets, fosters efficiency. New information is constantly being absorbed by investors and reflected in security returns. The instantaneous processing of data means that future rates of return cannot be predicted by past returns. These postulations have been codified under the Efficient Market Hypothesis (EMH). This paper studies the characteristics of thirteen small European stock markets, in order to find international support for the presence of efficiency in financial markets. The thirteen bourses are located in Belgium, Denmark, Finland, Greece, Ireland, Luxembourg, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and Turkey. Attempts to consistently encounter the EMH have failed. Faced with the arrival of unexpected information, agents do not adjust prices immediately in accordance with the news. The implications of new information on financial derivatives are often exaggerated and therefore, time for adjustment is required to equate the price level with the mean rate of return. The Overreaction Hypothesis (OH) explains these inefficiencies by predicting that prices will be undervalued preceding unfavorable announcements. As Figure I indicates, favorable disclosures are foreseen to entice the market to establish equity prices above the average rate of return. Yet, the efficiency assumption retains its merit. In the face of abnormal returns and profiteering, the premise of efficiency is altered. Investors react to the arrival of unexpected information and the associated uncertainty rationally, by undervaluing the prices of securities (Lo and MacKinlay, 1990, 1997, 1999). Therefore, the prediction in the event of negative announcements coincides with the one proposed by the Overreaction Hypothesis. The Uncertain Information Hypothesis (UIH) models this rational behavior of agents in an uncertain environment. The theory predicts that return volatilities will increase following an announcement. Specifically, post-negative disclosure volatilities are greater than positive volatilities. The latter is a rational consequence of risk-averse agents attempting to err on the side of caution. Although there has been intense scrutiny of American institutions and, foreign Asian markets, smaller stock markets have often been ignored (for American institutions see: DeBondt and Thaler, 1985, 1987, 1990; Howe, 1986; Brown and Harlow, 1988; Brown, Harlow, and Tinic, 1988, 1993; Zarowin, 1989, 1990; and Conrad and Kaul, 1993; for foreign markets see: Hogholm, 2000; Ratner and Leal, 1999; and Gunaratne and Yonesawa, 1997). This is especially pertinent to secondary European markets. Their diminutive size, in terms of both the number of securities listed and investors, implies a lack of efficiency and could explain the absence of interest. …