Effect of Changes in Index Re-composition on Stock Prices and Volume: Study of Pakistani Stock Markets

Abstract

This study examines the effect of KSE-100 and LSE-25 index re-composition on addition and deletion of non-financial firms from the sample period 2004-2014. To study the price effect, event study methodology is used for calculating the average abnormal returns (AARs) and cumulative average abnormal returns (CAARs) for both stock indices. Trading volume effect is also analyzed in event window by using volume ratio. The findings of this study show that Positive and significant average abnormal return (AAR) of 0.52% for KSE-100 index and 1.176% for LSE-25 index are observed on announcement day of inclusion. These results support the information content hypothesis in both stock indices. In case of deletion of firms no negative average abnormal returns were found on announcement day, so it do not support the information content hypothesis as the prices of deletion of firms do not decrease on announcement day. Results for KSE-100 index and LSE-25 index show a temporary change in prices of added and deleted stocks of both stock indices, not a permanent and prices reverses after a few days of announcement. Hence it supports the price pressure hypothesis and rejects the downward sloping demand curve hypothesis. Finally this study can help in better resource allocation and investment decisions regarding index re-composition for investors and traders of Pakistani and other developing countries stock markets.

Keywords: Inclusion, exclusion, KSE-100, LSE-25, market model and event study