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Essays on Stock Return Predictability and Market Efficiency

Jiang, Lei (2011)
Dissertation (143 pages)
Committee Chair / Thesis Advisers: Maasoumi, Esfandiar; Molodtsova, Tetyana
Committee Members: Chordia, Tarun ; Krause, Stefan ; Luger, Richard
Research Fields: Economics, General
Keywords: Stock liquidity; Taylor rule; Commonality in liquidity; Stock return predictability; Order imbalance; Market efficiency
Program: Laney Graduate School, Economics
Permanent url: http://pid.emory.edu/ark:/25593/90xdr

Abstract

I explore how the Taylor rule fundamentals affect stock liquidity at the market level and at the individual stock level, commonality in stock liquidity, stock return predictability and financial market efficiency.

In the paper, "Stock Liquidity and the Taylor Rule", I establish the linkage between stock liquidity and real time macroeconomic variables through the Taylor rule. Contractionary monetary policy as indicated by Taylor rule fundamentals changes the funding liquidity and financial constraints faced by market makers in the stock market, which affects their ability and incentive to provide liquidity and commonality in liquidity. A one percentage point rise in the output gap (inflation) lowers market liquidity by 4.3 percentage points (4.6 percentage points). An increase in the output gap (inflation) by one percentage point drives up commonality in liquidity by 1.6% (1%) from the supply side. When commonality of liquidity is evaluated from the demand side, the effect of the Taylor rule is not as strong as the wealth effect.

In the "Stock Return Predictability and the Taylor Rule" paper co-authored with Tetyana Molodtsova, we link the business condition variables to stock returns via monetary policy channels. We use real time data for inflation and output gap, which precisely mimic the decision making environment of investors in the stock market, to test for stock return predictability. The Taylor rule model has higher forecasting ability than the constant return model and long term yield model. The predictability of Taylor rule fundamentals during recent 30 years is robust to different measures of the output gap and different window sizes.

In the paper, "Order imbalance, liquidity and market efficiency: evidence from the Chinese stock market", I evaluate the Chinese stock market efficiency by past stock return information and order imbalance information. Order imbalance may predict returns when there is no designated market maker. It takes longer for information regarding past returns and order imbalance to be incorporated into stock prices in China than in the U.S.. The process of converging to efficiency depends highly on stock liquidity.

Table of Contents

Table of Contents

Preface...1

Chapter 1 Stock Liquidity and the Taylor Rule

1. Introduction...17
2. Model of Liquidity with Taylor rule...22
3. Data...27
4 Empirical Results...33

4.1 Taylor rule and stock market liquidity...33
4.2 The effect of Taylor rule fundamentals on liquidity of individual stocks...39
4.3 Other measurements of liquidity, market capitalization ranked, liquidity ranked portfolio...41
4.4 Taylor rule and commonality in liquidity: from the demand and supply side...43

5 Conclusion...48
References...50

Chapter 2 Stock Return Predictability and the Taylor Rule

1. Introduction...69
2. Stock Return Model...74
3. Data...78
4. Model Comparisons...80

4.1 Out-of Sample Tests Based on MSPE Comparisons...80
4.2 Tests Based on Matusita-Bhattacharya-Hellinger Measure of Dependence...83
4.3. Certainty Equivalence Tests...84

5. Empirical Results...85

5.1 In-Sample Estimation Results...85
5.2 Out-of-Sample Model Comparisons...87

6. Conclusions...90
References...91

Chapter 3 Order imbalance, liquidity and market efficiency: evidence from the Chinese stock market

1 Related Literature...107
2 Data...109
3 Weak form efficiency in Chinese stock market...111
4 Predictability of Order Imbalance on Stock Return...114
5 The effect of Liquidity on Predictability...118
6 Conclusion...122
References...123

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