2004.21
Addition to the Nikkei 225 Index and Japanese Market Response:

Temporary Demand Effect of Index-arbitrageurs
Katsuhiko Okada
Nobuyuki Isagawa
Kenya Fujiwara

Addition to the Nikkei 225 Index and Japanese Market Response:
Temporary Demand Effect of Index-arbitrageurs

Katsuhiko Okada (Kwansei Gakuin University),
Nobuyuki Isagawa (Kobe University)*,and Kenya Fujiwara (Kobe University)
Abstract

We examine the Japanese stock market response to addition to the Nikkei 225 Indexduring the period from 1991 to 2002. Much as in the case of the U.S. markets, the stock
prices of added firms go up on the announcement date, continue to increase until one
day prior to the effective change date, and then decrease on the change date. We identify
that the stock price increase in the run-up period (between the announcement date andthe change date) is temporary, because it is completely canceled out by the stock pricedecline following the change date. We also find that the excess demand ofindex-arbitrageurs for shares of newly added firms is the main source of the temporarystock price increase.

JEL classification: G14
Keywords: Index effect, Nikkei 225,
Demand shock, Japanese markets*

Corresponding author. Graduate School of Business Administration, Kobe University,
2-1 Rokkodai, Nada, Kobe, Hyogo 657-8501, Japan. Tel: +81-78-803-6907; Fax:
+81-78-803-6976. e-mail address: isagawa@kobe-u.ac.jp
11. Introduction

A number of empirical studies, such as those of Shleifer (1986), Harris and Gurel(1986), Lynch and Mendenhall (1997), and Wurgler and Zhuravskaya (2002), haveexamined the stock price effect associated with a change in the composition of the S&P
500 Index. All of these studies reported that additions to the S&P 500 Index increased
the stock prices of added firms. Some recent studies have focused on the non-U.S. stock
indices. For example, Chakrabarti, Huang, Jayaraman, and Lee (2004) studied price andvolume effects of changes in the MSCI index, which is the most popular international
stock index.
Despite the fact that the Japanese stock market has the second largest market
capitalization following that of the U.S., few studies have focused on the changes in thecomposition of the Nikkei 225 Index, which is the most broadly quoted stock index in
Japanese stock markets. Hanaeda and Serita (2003) examined the impact of the large
composite change of the Nikkei 225 Index on April 24, 2000.1 However, the restrictionof their examination to a single event may have undermined the accuracy of theirassessment of the price effect of the Nikkei 225 composite change. Furthermore,concern about the calendar clustering effect arises from a single event study.
Using a relatively large sample of changes in the Nikkei 225 Index, we investigate
the stock price behavior of firms newly added to the index.2 Our sample consists of 69
firms added to the Nikkei 225 Index during the period from 1991 to 2002.

1

The composite change on April 24, 2000 was a very large event in the sense that 30

firms were added to (and deleted from) the Nikkei 225 Index simultaneously.
2

Although Liu (2000) examined the effects of stock price and trading volume

associated with changes in the Nikkei 500 Index, this index is not particularly popular inJapanese markets.
2One goal of this study is to compare the market response to an event outside therealm of a firm’s discretion. Some empirical studies have reported a difference inmarket response between Japan and the U.S. when a firm undertakes equity issuance(Kang and Stulz (1996)) or changes its dividend policy (Dewenter and Warther (1998)).
Such financial strategies are at the discretion of the firm and the difference in the market
response is the proof that the same corporate behavior could be evaluated differently
depending on the markets. On the other hand, the decision to join a stock index is notmade by the added firm itself. If little difference in the stock market behavior isobserved between Japan and the U.S., then one may be able to argue that the market
reaction is identical when it comes to an event outside the corporate managers’
discretion.
We find that the stock prices of added firms rise significantly in response to theannouncements of additions. They continue to increase during the run-up period(between the day after the announcement and one day prior to the change date), andthen decrease on the effective date of the change. Such stock price behavior in Japanesemarkets is very similar to those in the U.S. (Lynch and Mendenhall (1997)) andinternational markets (Chakrabarti, Huang, Jayaraman, and Lee (2004)). While thepositive announcement effect is permanent, the run-up period stock price increase istemporary. The stock price rise in the run-up period is offset by the decline following
the change date.
There are two main lines of reasoning to account for the positive market response.
One interpretation, which we will refer to as the “information hypothesis”, is that thestock price of the newly added firms increases because the addition may convey soundand previously unavailable information about their future perspectives. Consistent with
the information hypothesis, Denis, Mcconnell, Ovtchinnikov, and Yu (2003) found thatthe firms experience unexpected significant improvements in realized earnings
following their addition to the S&P 500 Index. Jain (1987) and Dhillon and Johnson3

(1991) also reported empirical findings in support of the information hypothesis.
The other interpretation, which we will refer to as the “demand shock hypothesis”,
sheds light on the demand aspect of the index additions. The demand shock hypothesis
suggests that the excess demand from the index-tracking investors (e.g.,index-arbitrageurs and index fund managers) is the major source of the stock priceincrease upon addition. Harris and Gurel (1986) and Shleifer (1986) were the first to
demonstrate such a demand shock effect. While Harris and Gurel (1986) identified thetemporary demand shock on the stock price of added firms (the price pressure
hypothesis), Shleifer (1986) found the permanent demand effect (the downward-sloping
demand curve hypothesis).3
Recently, Lynch and Mendenhall (1997) and Wurgler and Zhuravskaya (2002)
applied the demand shock hypothesis to index additions from a somewhat different
angle. Lynch and Mendenhall (1997) investigated stock price behavior surrounding theeffective date of the change as well as the announcement date. This separation of thetwo event dates clarified the stock price behavior during the run-up period. They foundthat the stock price of the firms added to the S&P 500 Index continued to increaseduring the run-up period and decreased on the change date. They indicated that suchobserved stock price behavior was consistent with the demand shock scenario due toheavy index-fund trading around the time of the change date.
Wurgler and Zhuravskaya (2002) developed a theoretical model and examined
whether both the demand shock and the arbitrage risk affected the announcement effectsof firms added to the S&P 500 Index. In the efficient market, the excess demand due tothe portfolio alignment by the index-tracking investors can be cancelled out by the3Chen, Noronha, and Singal (2004) found an asymmetric price response between firms

added to and those deleted from the S&P 500 Index. They suggested that investor
awareness contributes to the asymmetric price effects.
4

rational arbitrageurs’ counter-trading. In the real world, however, there exists anarbitrage risk, and as a result, the risk-averse arbitrageurs would be expected to tradeless aggressively than required to offset the demand shock. 4 Consistent with thepredictions of the demand shock hypothesis, they found that the magnitude of theannouncement day returns of added firms had significant positive relationships withboth demand shock and arbitrage risk.
Another goal of our study is to investigate how the demand shock due to theindex-tracking investors affects the stock price behavior of firms newly added to the
Nikkei 225 Index. Since it is likely that the announcement day return is to some degreeaffected by the information, we focus on stock returns after the announcement date. As
suggested by Lynch and Mendenhall (1997), the index-tracking investors tend topurchase the added stocks as near as possible to the change date in order to minimize
the tracking error. Therefore, such a trading strategy on the part of the index-tracking
investors affects the volume and the stock price behavior surrounding the change date.
For each stock added to the Nikkei 225 Index, we measure the size of theindex-arbitrageurs’ demand shock and the stock’s arbitrage risk. Our focus is on theindex-arbitrageurs rather than the index funds, primarily because the cash-future
arbitrage balance on the Nikkei 225 was relatively large during our sample period. For
the index-arbitrageurs, the arithmetically averaged Nikkei 225 Index is less risky for
conducting the cash-future arbitrage trading than a capital-weighted index like the S&P
500.5 We find that the temporary abnormal returns observed in the run-up period are4

Shleifer (2000) stressed that, in the real world, rational arbitrage seems to be costly

for several reasons. Empirically, Pontiff (1996) found that market frictions constrain therational traders’ arbitrage process, such that closed-end fund prices can deviate fromtheir fundamental values.
5

For more details, see Section 2.
5related to the demand shock in a significantly positive manner. Index arbitrageurs’
rebalancing activity affects the stock price increase of added firms in the run-up window,
in which the information effect is less likely to be contained. We also find a positive but
insignificant relationship between arbitrage risk and the run-up period stock priceincrease.
The remainder of the paper is organized as follows. In Section 2, we discuss some ofthe details associated with the Nikkei 225 Index and the index-arbitrage trading. In
Section 3, we describe our addition samples and the methodology of our analysis. In
Section 4, we present the results of the stock price behavior surrounding the compositechange of the Nikkei 225 Index. In Section 5, we present the results associated with theeffects of the demand shock due to the index arbitrageurs’ rebalancing. In Section 6, weconclude the paper.

2. Changes in the Nikkei 225 Index and Index-Arbitrage Trading

In Japanese stock markets, there are two popular and widely used market indices:
the Nikkei 225 Index and TOPIX. While TOPIX is a value-weighted stock index
comprising approximately 1,600 stocks, the Nikkei 225 Index is a simple
price-weighted arithmetic average of a selection of 225 actively traded stocks on thefirst Section of the Tokyo Stock Exchange (TSE). Historically, the Nihon Keizai
Shimbun obtained a license from the Dow Jones Co., Ltd., to use the name, and theindex was published as the Nikkei Dow Average. In 1985, the Nihon Keizai Shimbunchanged the name of the index to the Nikkei Average Index, which is publicly known as
the Nikkei 225 Index in the marketplace.
The Nihon Keizai Shimbun has periodically reviewed the composition of the Nikkei
225 Index so that the index would effectively reflect the current structure of theJapanese industry. For example, in our sample period from 1991 to 2002, there were 38

6changes in the Nikkei 225 Index. In many cases, announcements of the review results
were made in September, only to be effective at the beginning of October. There were,on average, approximately 5 business days between the announcement date and theactual change date. Changes could also be made at any other time, provided a stock wasfound to be ineligible for the Stock Average.
The criteria used for changing the index composition included a component stock’s
trading volume and the market capitalization in the preceding three years. A constituent
stock would be deleted when its market liquidity, as measured by its trading volume,
fells out of the top half of the stocks on the first section of the TSE. Other reasons fordeletion included mergers, bankruptcy, and delistings. To fill the vacancies left by thedeleted stocks, candidates for addition must be selected. The criteria for addition
included the sector distribution (to keep the index well-balanced among industries) andthe market liquidity (i.e., within an industry, selecting firms with higher market
liquidity). All proposed changes were announced in Japanese newspapers.
The futures markets on the Nikkei 225 Index have been the most actively traded of
the stock index futures in Japan.6 It should be noted that about 80% of the index
arbitrage was being carried out on the Nikkei 225 Index.7 This is one of the mostprominent features that distinguish the Nikkei 225 Index from the S&P 500. In
particular, for the index arbitrageurs, an arithmetic-averaged index like the Nikkei 225
is less risky in terms of conducting cash-future arbitrage than is a capital-weighted
index like the S&P 500. Since a capital-weighted index has different weightings for its
component stocks, it is necessary for arbitrageurs to adjust their stock portfolios as theprice fluctuates. On the other hand, the Nikkei 225 Index can be entirely hedged with its

6

For example, see Japan Securities Research Institute (2002).

7

Interviews with several major arbitrageurs in Japanese stock markets have suggested

that roughly 80% of the arbitrage is carried out on the Nikkei 225 Index.
7

futures contract, regardless of the movement in the price of the component stocks. Thissafety feature for arbitrageurs promotes the cash-future arbitrage balance on the Nikkei
225 Index. Its balance usually exceeds 1 trillion yen (approximately 10 billion US
dollars), and sometimes exceeds 2 trillion yen (20 billion US dollars).

[Insert Table 1]

Table 1 provides information on the cash position of the stock index-arbitrages inJapanese markets during our sample period. Since the composite changes in the Nikkei
225 Index mostly occurred in September, we use data taken at the end of September of
each year. The table shows both the amount in million Yen (in the second column) andthe total number of shares in all arbitrage positions (in the third column) based on the
figure provided by the Tokyo Stock Exchange. Assuming that 80% of the index
arbitrage is on the Nikkei 225 Index, we estimate the number of shares per firm held by
the Nikkei 225 Index-arbitrageurs. Dividing this number by the total number ofoutstanding shares of the firm, we obtain the measure of demand shock due to therebalancing by the index-arbitrageurs.
The measure of the demand shock, indicated by DS, is the percentage of the added
firm’s shares relative to their outstanding shares to be purchased by the index
arbitrageurs when they face changes in the Nikkei 225 Index composition. Specifically,
we determine DS=AB/OUT, where AB is the number of an added firm’s shares that theindex arbitrageurs are to purchase to match the new composite, and OUT is theoutstanding number of shares of the firm. In our sample firms, DS is 2.38% on average,
as shown in Table 2.
Table 2 presents the average percentage of trading volume for sample firms over the
pre-announcement periods. On average, 0.25% of the firm’s outstanding shares were8

traded per day over the 100-day period prior to the announcement of (AD-100, AD-1).8
Similarly, 0.29% of the firm’s outstanding shares were traded per day over the 30-day
period prior to the announcement. Comparing DS with these values reveals the impactof the index-arbitrageurs’ trading on the stock behavior.

[Insert Table 2]

The typical trading behavior of the index-arbitrageurs facing a change in thecomposition of the Nikkei 225 Index is as follows. On the first trading day following
the announcement, the stocks added to the index are likely to be bought up by numerous
bidders. However, the index-arbitrageurs do not rebalance their portfolios until one dayprior to the change date (CD-1). This is because, for the index-arbitrageurs, it is of thehighest priority not to make a tracking error; thus the arbitrageurs would not dare to takeany risk during the interim between the announcement date and the change date. Byselling stocks deleted from the index and purchasing stocks added to the index at theclosing price on CD-1, the index-arbitrageurs can immunize tracking errors of their cash
stock portfolio. In reality, the arbitrageurs start to rebalance their portfolio a few
minutes before the closing bell on CD-1.9,10

8

Throughout the paper, day AD-t (day AD+t) denotes t days before (after) the

announcement date (AD), and day CD-t (day CD+t) denotes t days before (after) the
effective change date of the addition (CD).
9There is one scenario in which index-arbitrageurs would fail to track the index. Since

the TSE has a matching rule for the closing, stocks may not close for the day due to theseller-buyer imbalance. In such cases, index-arbitrageurs are unable to trade relevant
stocks, such that their portfolios would be subject to the subsequent price fluctuation. In
order to avoid this risk, index-arbitrageurs sometimes attempt to complete their9

3. Data and Methodology

Our original sample consists of 82 firms newly added to the Nikkei 225 Index in the
period between September 1991 and October 2002. We collect information regarding
the changes in index composition from Nihon Keizai Shimbun, which is the mostpopular economic newspaper in Japan. Since the Nihon Keizai Shimbun has a policy ofmaking an announcement of composite changes after the stock market is closed, we
define the announcement date as the first business day after the release of suchinformation.
From the 82 original samples, we eliminate some firms for two reasons. First, we
exclude 10 firms due to a lack of historical returns needed to estimate the market model
coefficients and the arbitrage risk measures. Secondly, because our study relies on theseparation between the announcement date and the effective date of the change, we
exclude 3 firms that were added immediately after the announcement.
Among the remaining 69 firms, 30 firms were added to the index on the same day(April 24, 2000). In order to overcome bias due to the clustering effect, we use two
methods. One is a regression model with dummy variables for the event period, and theother is the equally weighted portfolio approach.11 The results are similar under bothmethods (see Table 4). Since the reduction of 30 firms to one portfolio will cause a loss

rebalancing before the closing bell.
10

Managers of the Nikkei 225-type index funds are also averse to ignoring the index,

and thus could be expected to engage in similar behavior as index-arbitrageurs. Since
we could not obtain the complete data of the balance for the index funds, we do not
analyze the demand effect due to index-fund managers’ behavior.
11

For the clustering effects, see Peterson (1989) and Henderson (1990).
10

of information, for the most part in this paper, we present the results from the regression
model with dummy variables.
We calculate the daily stock returns by using the closing price taken from the
Nomura Aurora Database, which is widely used in Japan. The market model residual isconsidered as a firm’s abnormal return on any given day.12 This residual is calculated as
the difference between the actual return and the predicted return based upon the market
model parameter estimates and the market return for that day. The parameters of themarket model are estimated over a 200-day period between day AD-230 and day AD-31,
and we use TOPIX as the market index.
A cumulative abnormal return over the window from day t1 to day t2 is calculated bycumulating the daily abnormal returns over that window geometrically. The averageabnormal return on day t is denoted by AAR(t), and the average cumulative abnormal
return over the window of (t1, t2 ) is denoted by CAR (t1, t2 ).
The volume data are also obtained from the Nomura Aurora Database for each firm
added to the Nikkei 225 Index. In order to determine whether or not the trading activity
increases in the added firms on any given day in the event window, we calculate themean volume ratio proposed by Harris and Gurel (1986). The volume ratio for firm i on
day t, VRit, is calculated by
VRit =

Vit Vm,⋅Vmt Vi(1)where Vit is the trading volume for firm i on day t, Vmt is the trading volume for the total
firms included in the market portfolio of TOPIX on day t, and Vi and Vm are the average
trading volumes over the 200-day estimation period of (AD-230, AD-31) for firm i andthe total TOPIX, respectively. The sample average of the volume ratio on day t is12

We also attempted to calculate the abnormal returns of firms using themarket-adjusted return model, and observed no significant difference in the results.
11

denoted as MVRt. If the addition to the Nikkei 225 Index has no effect on the trading
volume, then MVR should not deviated widely from the expected value of 1
surrounding the announcement date and change date.

4. Stock Price Behavior Surrounding the Addition to the Nikkei 225 Index[Insert Table 3]Panel A of Table 3 presents the daily average abnormal return (AAR) and the mean
volume ratio (MVR) relative to the announcement date, and panel B of Table 3 presents
those values relative to the effective change date. For each of the 5 event days after theannouncement date (from AD+1 to AD+5), only those firms for which the change date
has not yet occurred were used to calculate AAR and MVR. Similarly, for each of the 5
event days prior to the change date (from CD-5 to CD-1), only those firms for which theannouncement date occurred on a prior day were used to calculate AAR and MVR.
The announcement of the addition to the Nikkei 225 Index pushes up the stock priceby a substantial margin. An abnormal return of 5.16% with a t-value of 13.42 isobserved on the announcement day. The t-value used to test the significance of each
AAR is based on the standard deviation of AAR over the 200-day estimation period. As
shown in Table 3, the average stock price of added firms continues to increase gradually
until one day prior to the change date (CD-1). The added firms experience a significant
positive abnormal return of 4.19% with a t-value of 10.92 on CD-1.
The announcement of the index addition is made in a well-publicized manner
through various media. If the market responds to the new information quickly, it isunlikely that any significant stock price reaction will be observed after theannouncement date. However, the average stock price of added firms is found tocontinue rising after the announcement date, and the magnitude of the increase is12

conspicuously large on CD-1. One possible explanation for this result would be that theindex-arbitrageurs tend to purchase added stocks on CD-1 in order to minimize the riskof making a tracking error, as discussed in Section 2.
Suppose that such a heavy trading of the index-arbitrageurs prior to the effective
change date shifts the stocks’ prices temporarily away from their equilibrium values. We
then would expect to observe the price reversal following the change date as theindex-arbitrageurs’ trading disappears. Consistent with this expectation, Table 3 showsthat the prices of the added stocks decline significantly on the change date (CD) and on
the next day (CD+1) as well. The average abnormal return on CD is -3.50% with at-value of -9.11, and that on CD+1 is -1.37% with a t-value of -3.57.
We also expect that the trading volumes of added firms would increase on CD-1 forthe same reason. The daily average trading volume ratio (MVR) over the event window
is presented in the last column of Table 3. As shown in the Table, MVR increases
abruptly on the announcement day, and continues to be greater than 1 after theannouncement date. The largest MVR is observed on CD-1, which is consistent with the
hypothesis that index-arbitrageurs rebalance their portfolios on that day. After thechange date, the MVR of added firms is found to decrease gradually.
Next, we examine the average cumulative abnormal returns (CAR) over the event
window. Similar to Lynch and Mendenhall (1997) and Chakrabarti, Huang, Jayaraman,and Lee (2004), we examine CAR over five event windows, i.e., the run-up window of(AD+1, CD-1), the release window of (CD, CD+7), the post-announcement windows of(AD+1, CD+7) and (AD+1, CD+10), and the total permanent window of (AD, CD+10).
We determine CD+7 as the release-ending day based on the same criterion used by
Lynch and Mendenhall (1997).

[Insert Table 4]13

Panel A of Table 4 represents the results of AAR on the announcement date andCAR over five event windows for our 69 samples (OLS with dummy variables). Panel
B of Table 4 represents those for 40 samples (portfolio approach). We report the resultsof the 40-sample case in order to show there is little difference in quantitative results
between the two methods. In the following, we primarily report the results of the
69-sample case.
If all of the added firms have windows of identical length, then the t-value used totest the significance of CAR (t1, t2) is given by
t = CAR(t1 , t2 ) / σ (t2 − t1 ) .

(2)

However, in the run-up window, the window’s length varies across firms. We therefore
used the average days of (t2-t1) among all 69 samples in equation (2).
On average, the addition samples experience a significant cumulative abnormal
return of 5.70% with a t-value of 6.99 over the run-up window of (AD+1, CD-1). Notethat most of this CAR is the abnormal return on CD-1 of 4.19%. In the release windowof (CD, CD+7), the average cumulative abnormal return of the added firms is -6.51%,
which is significant at a 1% confidence interval. The stock price rise in the run-up
window is completely erased by the decline during the release period. Naturally, in the
post-announcement windows of (AD+1, CD+7) and (AD+1, CD+10), the average
cumulative abnormal return is almost equal to zero.
Figure 1 plots the average cumulative abnormal return (CAR) for added firms
surrounding the announcement date and the effective change date. In the figure, theinterval between AD+1 and CD-1 is shown as five days, because the actual average
number of days of the interval was 5.5 days, inclusive of AD+1 and CD-1. The CAR isdisplayed as if each daily AAR over this interval were the interval’s CAR divided by
five.

14

[Insert Figure 1]

Figure 1 shows that the average stock price of the sample firms increases in
response to the announcement of the addition to the Nikkei 225 index. The averagestock price continues to rise over the run-up window, and then begins to revert to thelevel observed on the announcement date. In particular, the added firms experience a
substantial rise on one day prior to the change date (CD-1), and a large drop on thechange date (CD).13
This pattern of stock price behavior of added firms is very similar to that reported by
Lynch and Mendenhall (1997). Although the results are not reported in this paper, wehave confirmed that the stock price behavior of firms deleted from the Nikkei 225 Index
is also similar to that of counterpart firms deleted from the S&P 500. Thus, little
difference is observed between the Japanese and the U.S. markets in terms of the stock
price behavior associated with the composite changes in the popular stock index.14
The addition to the Nikkei 225 index produces a significant stock price increase on
the announcement date, and this rise is permanent rather than temporary. There are two
hypotheses that might account for this permanent increase in stock price. One is theinformation hypothesis and the other is the downward-sloping demand curve hypothesis.

13

As shown in Figure 1, there is no significant stock price change after CD+10. On theother hand, added firms experience a gradual stock price increase prior to theannouncement date. This may be because that some analysts report candidate firms foradding to the Nikkei 225 index based on the criteria for changing the index composition,and several investors take a long position based on the analysts’ reports.
14

Chakrabarti, Huang, Jayaraman, and Lee (2004, Table 1) reported essentially thesame pattern of stock price behavior in Japanese markets surrounding changes in the
MSCI.
15

However, it is difficult to specify which of the two provides a more plausible
explanation. And, as mentioned by Chakrabarti, Huang, Jayaraman, and Lee (2004),
these two hypotheses are not mutually exclusive.
The addition to the Nikkei 225 index also produces a continuous stock priceincrease into the run-up window. Contrary to the announcement effect, the run-up
period stock price increase is completely neutralized by the stock price decline in thefollowing release window, and is therefore temporary. In the next section, we examine
the effects of the demand shock caused by the portfolio rebalancing on the part of theindex arbitrageurs.

5. Effects of Index-arbitrageurs’ Demand ShockPrevious studies such as those of Harris and Gurel (1986), Lynch and Mendenhall(1997), and Wurgler and Zhuravskaya (2002) have suggested that the demand shock due
to the index-tracking investors’ trading affects the stock price behavior of firms newly
added to the index. As argued in Section 2, it is likely that, in the case of the Nikkei 225
Index, the rebalancing of the cash stock portfolio by the index-arbitrageurs has an
impact on the stock price of added firms. In this section, we will investigate this issue indetail.
Our hypothesis is as follows. Since the information effect is likely to be reflected in
the stock price on the announcement date, the excess demand of the index-arbitrageurs
for the newly added firms causes their stock price to increase in the run-up window.
Thus, we expect the cumulative abnormal return in the run-up window of (AD+1,
CD-1) to be positively related to the measure of demand shock created by theindex-arbitrageurs.
If an excess demand shock hits the market, it may shift the stock price away from its
fair value, because rational arbitrage activity does not function in a perfect way as

16

predicted by the efficient market hypothesis. In an efficient market setting, the rational
arbitrages should have the opposite effect of the unsophisticated demand shock andthereby return the stock price to its fair value. However, as argued by Shleifer (2000)
and Wurgler and Zhuravskaya (2002), such arbitrage activity entails risk on the part of
the arbitrageurs and falls short of the necessary corrective force. The larger the arbitrage
risk of the added stock, the more it is overvalued by the excess demand shock.
Therefore, we expect the cumulative abnormal return in the run-up window to have apositive relationship to the extent of the stock’s arbitrage risk.
For the purpose of testing the above hypothesis, the cumulative abnormal return in
the run-up window is regressed on the demand shock and arbitrage risk measures. As
explained in Section 2, the measure of the demand shock, DS, is the percentage of theadded firm’s shares relative to its outstanding shares to be purchased by index
arbitrageurs. Taking into account the cross-held shares in the Japanese firms, we also
use another measure of the demand shock, DSF. The measure of DSF, the ratio of
demand shock to free float, is the percentage of the added firm’s free float to bepurchased by index arbitrageurs. We collected data on the free float of firms from the
Toyo Keizai Data Bank. In our sample firms, DSF was 6.58% on average, which ismuch larger than the average DS of 2.38%. Under the demand shock hypothesis, we
expect that DSF would have a stronger influence on temporary stock price than DF.
As a measure of arbitrage risk, which is designated as RISK, we use the variance ofthe residuals of the market model over a 200-day estimation period. The same arbitrage
risk measure is also employed by Wurgler and Zhuravskaya (2002), Hanaeda and Serita(2003) and Chakrabarti, Huang, Jayaraman, and Lee (2004).15

15

Wurgler and Zhuravskaya (2002) used another measure of arbitrage risk based on

firms that match characteristics of the added firm. They identified that two measures ofarbitrage risk were very similar in magnitude and were highly correlated.
17

Panel A of Table 5 presents the regression results for the stock returns in the run-up
period. The regression results show that the abnormal stock return of the added firms
during the run-up period has a significant positive relationship with the measure of theexcess demand shock. The index-arbitrageurs’ excess demand is an important factor forthe temporary stock price increase. The results of model (1) and model (2) indicate that
DSF has a more significant effect than DS, which is in line with our initial prediction. Itshould be noted that the regression results provide plausible explanations with large
R-squares. Model (1) and model (2) can account for about 25% and 34% of the total
variation in abnormal stock price increases in the run-up window, respectively.
Model (1) and model (2) also show that abnormal stock increases are related in apositive manner with the measure of the stock’s arbitrage risk (RISK). Although theresults are consistent with the qualitative prediction, they are not statistically significant.
Hanaeda and Serita (2003) reported that the measure of the arbitrage risk based upon thestandard deviation of the error term of the market model had no significant impact on
the announcement effect of addition to the Nikkei 225 Index. Such a measure ofarbitrage risk might not be effective for explaining temporary stock price changes in
response to a change in the Nikkei Index.16
Next, we focus on the stock price decrease in the release window of (CD, CD+7).
Panel B of Table 5 presents the regression results for the stock returns in the releasewindow. Since the index arbitrageurs retain the stocks that they purchased before thechange date as part of their cash portfolios, it is likely that the temporary demand shock
will disappear following the change date. Then, we expect that neither DS nor DSF will

16

In their sample of all firms newly added to the MSCI Index, Chakrabarti, Huang,

Jayaraman, and Lee (2004, Table 5) found no significant relationship between stock
price behavior and the measure of arbitrage risk based on the residuals of the market
model.
18

have a significant effect on the release period CAR. The results are consistent with thisprediction, because the coefficient of the demand shock in models (3) and (4) is not
significant.
The arbitrage risk has a negative but insignificant relationship with the stock pricebehavior following the change date. The coefficients of RISK in models (1) and (2)show that the larger the arbitrage risk of the added stock, the more it is overvalued in the
run-up period. Then, in the release period, the overvaluation due to arbitrage risk may
disappear gradually.
In the regression model, we include the run-up period cumulative abnormal returns,
denoted by RUN-UP. The results in models (3) and (4) show that the stock pricebehavior in the release period has a significant relationship with that in the run-up
period. The more the stock price increases in the run-up period, the more it goes down
after the change date. We also perform the same regression analysis for cumulative
abnormal returns in the two-day period of (CD, CD+1), and we obtain essentially thesame results as those obtained for the release window.

6. Conclusion

This paper investigated the stock price behavior of firms newly added to the Nikkei
225 Index, which is the most popular stock index in the Japanese stock markets. We
identified the significant positive stock price increase for added firms on theannouncement date. The stock price continues to go up into the run-up window (until
one day prior to the effective change date), and subsequently declines on the change
date. Such stock price behavior in Japanese markets is very similar to that in the U.S.
reported by Lynch and Mendenhall (1997). With regard to the addition to the major
stock index, which is not under the firm’s discretion, there is little difference in themarket responses of the Japanese and U.S. markets.

19

We then investigated how the demand shock from index-arbitrageurs affects thestock price behavior surrounding the index addition. We found that the cumulative
abnormal return in the run-up window is positively related to the demand shock. Thisfinding is consistent with the hypothesis that the excess demand of index-arbitrageurs
for newly added firms pushes up stock prices. We also found that the magnitude of thestock price reversion in the release window is significantly related only to the run-up
period abnormal return. There was no significant relationship between the magnitude ofstock price reversion and excess demand shock. Taking into account the fact that theindex-arbitrageurs retain the stocks purchased in the run-up period, this finding is quiteplausible.
In sum, the stock price of firms newly added to the Nikkei 225 Index significantly
go up in response to the announcement. This announcement effect is likely to bepermanent. However, the post-announcement stock price rise in the run-up window
turns out to be temporary, because most of the cumulative gains in the window areoffset by the stock price declines that follow after the effective change day. The demand
shock due to the index-arbitrageurs’ portfolio rebalancing has a significant influence on
this temporary stock price increase.
[2004.12.13 688]

References

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of Changes in MSCI Indices−Nature and causes, Journal of Banking and Finance,
forthcoming.

Chen, H., Noronha, G., and V. Singal, The Price Response to S&P 500 Index Additions
and Deletions: Evidence of asymmetry and a New Explanation, Journal of Finance20

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Conflicts: Evidence from a Comparison of the Dividend Policies of Japanese and US
Firms, Journal of Finance 53, 879-904.

Dhillon, U., and H. Johnson, 1991, Changes in the Standard and Poor’s 500 List,
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Hanaeda, H., and T. Serita, 2003, Price and Volume Effects Associated with a Change in
the Nikkei 225 List: New Evidence from the Big Change on April 2000, International
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Harris, L., and E. Gurel, 1986, Price and Volume Effects Associated with Changes in the
S&P500 List: New Evidence for the Existence of Price Pressure, Journal of Finance
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Henderson, G., 1990, Problems and Solutions in Conducting Event Studies, Journal of
Risk and Insurance 57, 282-306.

Jain, P., 1987, The Effect on Stock Price from Inclusion in or Exclusion from the
S&P500, Financial Analysts Journal 43, 58-65.

Japan Securities Research Institute, 2002, SECURITIES MARKET IN JAPAN 2000.

21

Kang, J-K., and R. Stulz, 1996, How Different is Japanese Corporate Finance? An
Investigation of the Information Content of New Security Issue, Review of Financial
Studies 9, 109-139.

Liu, S., 2000, Changes in the Nikkei 500: New Evidence for Downward Sloping
Demand Curves for Stocks, International Review of Finance 1, 245-267.

Lynch, A., and R. Mendenhall, 1997, New Evidence on Stock Price Effects Associatedwith Changes in the S&P 500 Index, Journal of Business 70, 351-383.

Peterson, P., 1989, Event Studies: A Review of Issues and Methodology, Quarter
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Pontiff, J., 1996, Costly Arbitrage: Evidence From Closed-End Funds, Quarterly
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Wurgler, J., and E. Zhuravskaya, 2002, Does Arbitrage Flatten Demand Curves for
Stocks?, Journal of Business 75, 583-608.

22

Table 1: Cash Position in Index-Arbitrage during 1991-2002

Year

Total number of shares

Estimated number ofAmount inin all arbitrage positions

shares per firm in the225

million Yen(in 1,000 shares)

arbitrage position(in 1,000 shares)*1991

1,138,675

1,014,648

3,607

1992

580,579

741,334

2,635

1993

1,205,743

1,254,016

4,458

1994

737,596

771,877

2,744

1995

1,882,532

2,181,199

7,755

1996

2,796,620

2,757,016

9,802

1997

1,369,777

1,547,996

5,504

1998

538,367

752,001

2,673

1999

801,750

827,508

2,942

2000

3,084,502

2,186,443

7,774

2001

1,507,301

1,599,583

5,687

2002

938,608

980,718

3,487

Note. All values are for the end-of-September of each year. The amount in million yen(the second column) and the total number of shares held in the cash position ofindex-arbitrage (the third column) are reported by the Tokyo Stock Exchange. The forthcolumn shows the estimated number of shares per firm held in the Nikkei 225-type
arbitrage positions.
*

Calculated by multiplying the total number of shares held by all arbitrage positions(the third column) by 0.8 and dividing it by 225.

23

Table 2: Comparison of Demand Shock to Trading Volume in the
Pre-announcement Periods

Sample Mean (n=69)

Standard Deviation

DS=AB/OUT

2.38%

0.0190

Average V/OUT(AD-100, AD-1)

0.25%

0.00045

Average V/OUT(AD-30, AD-1)

0.29%

0.00045

Note: DS=AB/OUT is the measure of demand shock due to the rebalancing byindex-arbitrageurs as explained in the text. Average V/OUT (AD-100, AD-1) is theaverage percentage of the added firm’s trading volume (to outstanding shares) over the
100-day period of (AD-100, AD-1). Average V/OUT (AD-30, AD-1) is that over the
30-day period of (AD-30, AD-1).

24

Table 3: Daily AAR and MVR Surrounding Addition to the Nikkei 225 Index
Panel A: AAR and MVR relative to the Announcement Day (AD)Days relative
to AD

Number of
Samples

AAR (%)

t-value

MVR

AD-10
AD-9
AD-8
AD-7
AD-6
AD-5
AD-4
AD-3
AD-2
AD-1
AD
AD+1
AD+2
AD+3
AD+4
AD+5

69
69
69
69
69
69
69
69
69
69
69
68
65
51
50
16

0.03
0.60
-0.09
0.15
-0.32
0.74
-0.09
1.06
0.14
0.59
5.16
0.55
2.59
1.35
1.01
0.26

0.01
1.57
-0.23
0.38
-0.83
1.92*
0.24
2.75***
0.35
1.53
13.42***
1.42
6.74***
3.51***
2.63***
0.68

1.06
1.04
1.06
1.04
1.09
1.03
1.06
1.26
1.21
1.38
4.45
4.21
4.88
3.48
3.44
2.37

Panel B: AAR and MVR relative to the Change Day (CD)Days relative
to AD

Number of
Samples

AAR (%)

t-value

MVR

CD-5
CD-4
CD-3
CD-2
CD-1
CD
CD+1
CD+2
CD+3
CD+4
CD+5
CD+6
CD+7
CD+8
CD+9
CD+10

16
50
51
65
68
69
69
69
69
69
69
69
69
69
69
69

0.31
0.83
0.31
1.67
4.19
-3.50
-1.37
-0.28
0.25
-0.53
-0.76
0.21
-0.53
-0.03
0.47
-0.38

0.79
2.16**
0.81
4.35***
10.92***-9.11***-3.57***
-0.73
0.65
-1.38
-1.98*
0.56
-1.39
-0.08
1.21
-0.99

2.18
2.19
3.25
4.40
8.21
4.23
2.30
2.20
3.40
3.72
2.51
1.83
1.60
1.77
1.81
1.46

Note: AAR is the average abnormal return and MVR is the mean volume ratio for the specified day
in the event period. t-value is the statistic used to test the null hypothesis that AAR=0.
*significant at the 10% level, ** significant at the 5% level, *** significant at the 1% level.

25

Table 4: Cumulative Abnormal Returns over Four Event Windows
Panel A: 69-sample case
Event Window

Event Days

Average Days

CAR (%)

t-value

Announcement day

AD

1

5.16

13.42***

Run-up Window(AD+1, CD-1)

4.52

5.70

6.99***

Release Window(CD, CD+7)

8

-6.51

-5.99***

Post-AD Window 1(AD+1, CD+7)

12.52

-0.81

-0.595

Post-AD Window 2(AD+1, CD+10)

15.52

-0.75

-0.50

Total Permanent(AD, CD+10)

16.52

4.40

2.82***

Panel B: 40-sample case (39 individual firms and one portfolio)
Event Window

Event Days

Average Days

CAR (%)

t-value

Announcement day

AD

1

4.94

12.41***

Run-up Window(AD+1, CD-1)

4.9

5.91

6.70***

Release Window(CD, CD+7)

8

-5.77

-5.13***

Post-AD Window 1(AD+1, CD+7)

12.9

0.13

0.09

Post-AD Window 2(AD+1, CD+10)

15.9

0.39

0.25

Total Permanent(AD, CD+10)

16.9

5.33

3.26***

This table represents the results of average abnormal returns (AAR) on theannouncement date and cumulative abnormal returns (CAR) for five different event
windows for two samples.
***significant at the 1% level26

Table 5: Cross-Sectional Regressions of CARs
Panel A: Regression Results of CAR in the run-up window of (AD+1, CD-1)
(1)

(2)

Constant-0.004 (-0.12)-0.025 (-0.71)

DS

2.45 (4.69)***1.10 (5.81)***

DSF
RISK

0.50 (0.42)

0.54 (0.53)

R2

0.25

0.34

Sample Size

69

69

Panel B: Regression Results of CAR in the release window of (CD, CD+7)
(1)

(2)

Constant-0.05 (-1.20)-0.05 (-1.39)

DS

0.57 (1.00)

DSF

0.32 (1.39)

RISK-0.97 (-0.87)-0.87 (-0.78)

RUN-UP-0.29 (-2.55) ***-0.33 (-2.75)***

R2

0.19

0.02

Sample Size

69

69

Note: Dependent variables are CAR in the run-up window (Panel A) and CAR in therelease window (Panel B). DS is the measure of demand shock based on the total
outstanding shares, DSF is the measure of demand shock based on the free float, and
RISK is the measure of arbitrage risk. RUN-UP is the run-up period CAR. The t-value
is given in the parentheses.
***
significant at the 1% level.

27

Figure 1: CAR for Firms newly added to the Nikkei 225 Index
CAR
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%

10
-20

-10

AD

C

20

Days relative to theDEvent

Note: AD is the announcement date and CD is the effective change date. Since the number of trading days between
AD and CD varies across firms, the interval between AD+1 to CD is displayed 5 days (actual average=5.5 days). The
CAR is displayed as if each daily AAR over this interval were the interval CAR divided by five.

28

Discussion Paper
No.
2003・1
2003・2
2003・3

2003・5

AuthorKatsuhiko Kokubu
Kazuhiro Tanaka
Fumitoshi Mizutani
Shuji Uranishi
Yang Jia Yin
Koji Okubayashi
Mitsutoshi Hirano

2003・6

Kazuhisa Otogawa

2003・7

Nobuyuki Isagawa
Tadayasu Yamashita
Kenji Kutsuna
Marc Cowling

2003・4

2003・8

2003・9

Noriko Masumura

2003・10 Nobuyuki Isagawa
Katsuhiko Okada
2003・11 Mitsutoshi Hirano
2003・12 Kenji Kutsuna
Richard Smith
2003・13 Kenji Kutsuna
Janet Kiholm Smith
Richard L. Smith
2003・14 Hideya Kubo
2003・15 Hideki Murakami
2003・16 Norio Kambayashi
2003・17 Nobuyuki Isagawa
2003・18 Nobuyuki Isagawa
2003・19 Huang Lin
2003・20 Koji Okubayashi
2003・21 Nobuyuki Isagawa
2003・22 Keizo Mizuno
Fumitoshi Mizutani
Noriyoshi Nakayama
2003・23 Kenji Kutsuna
Nobuyuki Harada

2003・24 Shigeki Sakakibara
Takashi Yamasaki
2003・25 Michihiro Ozawa
2003・26 Atsushi Takao

Title
Environmental Accounting for Corporate Management
Embeddedness and Entrenchment of Managers
The Effects of Privatization on TFP Growth and Capital
Adjustments
Labour Turnover of Japan-Affiliated Companies inShanghai
Generation and Resolution of Asymmetric Information in
Human Resource Management –In the Cases of Job
Rotation in Two Retailers in JapanMarket Liquidity around Quarterly Earnings
Announcements
Lender’s Risk Incentive and Borrower’s Risk Incentive
Determinants of Small Business Loan Approval:
Evidence from Japanese Survey after 1997 Financial
CrisisVoluntary Corporate Disclosure and the Cost of Debt:
The Case of Quarterly Reporting
Corporate Financial Strategy and Stock Price Behavior
in a Noise Trader Model with Limited Arbitrage
Two Modes of Economic Organization in the Duality
Principle and Asymmetric Personal Information
Why Does Book Building Drive Out Auction Methods of
IPO Issuance? Evidence from Japan (Revised version)
Banking Relationships and Access to Equity CapitalMarkets:
Evidence from Japan’s Main Bank System
The Present Condition and Problem of JapaneseCorporate Pension Systems
An empirical analysis of the spillover and dynamic
effects of low-cost airline’s presence on rival’s price:
US duopoly case
Japanese Style of Management Education
Unwinding of Cross Shareholding for BusinessRestructuring
Unwinding of Cross Shareholding: A Signalling
Approach
Strategies and Store Development of Carregour in the
Chinese Continent
Emp lo yme nt Situation and Measur es for
In cr easing Emp lo yme nt Oppor tun ities;
Th e Cas e o f Jap an
L end er ’s Risk In cen tiv e and D eb t Forg iv ene ss
Industrial Diversity and Metropolitan Unemployment
Rate(in Japanese)(in Japanese)

Date
1／20032／20032／2003(in Japanese)

3／2003(in Japanese)

3／20033／2003(in Japanese)

3／20033／2003(in Japanese)

4／20034／2003(in Japanese)

5／20035／20035／2003(in Japanese)

6／2003(in Japanese)

7／2003(in Japanese)(in Japanese)

7／20037／2003(in Japanese)

7／2003(in Japanese)

8／2003

Small Business Managers as Latent Informal Investors inJapan:
Evidence from a country with a bank-based financial
systemThe First Half of The Year Effect in Japanese Stock (in Japanese)
MarketAudit Risk Model with conditional probability and the (in Japanese)
importance of risk assessment
A Note on the Securitilization of Catastrophe Risk
(in Japanese)〜 A Study by Especially Attention -Focusing toInsurance Linked Securities 〜

8／20038／20039／20039／20039／2003
10／2003
10／2003

Discussion Paper
No.
Author
2003・27 Koji Okubayashi
2003・28 Nobuyuki Isagawa
Tadayasu Yamashita
2003・29 Mitsutoshi Hirano
2004・1

Koji Okubayashi

2004・2
2004・3

Huang Lin
Mitsutoshi Hirano
Yoshihiro Ogawara

2004・4
2004・5

2004・7

Katsuyoshi Takashima
Susumu Ogawa
Manabu Mizuno
Susumu Ogawa
Manabu Mizuno
Susumu Ogawa

2004・8Mitsutoshi Hirano

2004・9Hideki Murakami

Title
Industrial Relations in a Changing Economy: Japan’s
Experience
Debt Forgiveness and Stock Price Reaction of Lending
Bank: Theory and Evidence from Japan
Self-Reliance Career Development via Change in
Organization Mode of Japanese Firm
New Trends of Japanese Management under IT
Revolution
The Chinese Companies in the Globalization
Change in Organization Mode and Asymmetric Personal
Information via Merchandising Process Reengineering−
From a Case of Big Box Retailer in Japan−
Competitive Structure of E-Commerce
Testing CVS folk theories

Date
11／2003
12／2003(in Japanese)

12／2003
1／2004(in Japanese)(in Japanese)

1／20041／2004(in Japanese)(in Japanese)

2／20042／2004CVS Folk theories and systemic advantages(in Japanese)

2／2004Seven-Eleven's Systemic Advantages: its integrity andflexibility
Core Human Resources Management via Change in
Organization Mode
An Empirical Analysis of Low-cost Entry's Effect onMarket Performance: The case of 3-firm US Oligopoly
Air Market
Positive Effects of Know-How Disclosure to Potential
RivalsThe Half-year Effect of the Japanese Stock Returns andFour Factor model
An evolution of User-driven Business Models: A casestudy of MUJI・net
The innovation of the selling process and management:
the case of IBM
Aggregate Accrual Approach in Discretional Behavior
ReseachSeven-Eleven's Systemic Advantages:
Multi-cluster product Development
Some Notes on the Weather Derivatives & Temperature
Swap in Japan(in Japanese)

3／2004(in Japanese)

3／2004(in Japanese)

5／2004(in Japanese)

5／2004(in Japanese)

6／2004(in Japanese)

6／2004(in Japanese)

7／2004(in Japanese)

7／2004(in Japanese)(in Japanese)

8／20048／2004
10／2004

2004・18 Takayoshi Okabe

Premature Revenue Recognition Drived by the Market (in Japanese)
Competition

11／2004

2004・19 Nobuyuki Isagawa

Cross Shareholding and Unwinding of
Shareholding under Managerical Entrenchment

12／2004

2004・20 Hideki Murakami

An Empirical Analysis of Low-cost Entry's Effect on (in Japanese)
Market Performance: The case of 3-firm US Oligopoly
Air Market

12／2004

2004・21 Katsuhiko Okada
Nobuyuki Isagawa
Kenya Fujiwara

Addition to the Nikkei 225 Index and Japanese Market
Response:
Temporary Demand Effect of Index-arbitrageurs

12／2004

2004・6

2004・10 Manabu Mizuno
Susumu Ogawa
2004・11 Shigeki Sakakibara
NaoshiYamazaki
2004・12 Susumu Ogawa
Hidehiko Nishikawa
2004・13 Hiroshi Takamuro
Junzo Ishii
2004・14 Takayoshi Okabe
2004・15 Susumu Ogawa
2004・16 Susumu Ogawa
2004・17 Atsushi Takao

Cross