The impact of institutional development on stock prices in Pakistan

Abstract

This study investigates the impact of regulatory policy changes and institutional development on stock prices in Pakistan between 1980 and 1994. Weekly stock price behaviour during the period when the market was highly regulated and segmented is compared with that during the period of financial and regulatory reforms. After institutional development and financial reforms, the risk premia per unit of beta in Pakistan increased significantly, particularly between July 1991 and December 1994. The time-varying risk premium model provided evidence of a significant relationship between risk and returns during all sub-periods, except the first sub-period of reforms. The volatility in returns and the persistence in volatility was evident only during reform period. The non-synchronous trading effect was evident over the reform period as a whole but not during any of the non-reform or reform sub-periods. Only higher risk portfolios indicated consistent patterns with the market index. The multivariate tests could not reject the efficiency of the KSE value-weighted market index. The parametric test statistics indicated no abnormal return for the control and reference portfolios during both the non-reform and reform periods. The spread in cumulative abnormal returns and buy-and-hold returns was higher during the reform period than the non-reform period further supports the hypothesis that portfolio returns were more volatile during the reforms. The risk premia for industry portfolios were higher during the reform period, particularly during the second sub-period of reforms. More industries showed evidence of the theoretical relationship between risk and returns prior to reform. The volatility in industry returns was more pronounced during the reform period, particularly during the first period of reform. In most cases, highly levered industries indicated stronger negative relationship between return and volatility change than the less levered industries. The leverage effect was better explained during the non-reform than the reform period. The equity-based Islamic portfolio performed significantly different than non-Islamic portfolios. The Modarabah stocks exhibited a significant relationship between risk and return throughout the reform period, whereas the non-Islamic stocks indicated no mean-variance relationship. Both the Modarabah and leasing indicated volatility in returns during the reform period. The non-Islamic portfolio did not indicate any significant volatility in returns. Only leasing stocks indicated non-synchronous trading impact during the overall reform period. The investors were sensitive to tax impositions on dividend income and required additional excess return before tax return, higher than under a more relaxed tax regime. The clientele effect was not significant over both tight and relaxed tax regimes except for investors in medium marginal tax bracket under a more relaxed tax regime. The required return on non-dividend paying stocks was positive and significant during tight tax regime as these stocks pay a premium to attract investors to absorb these stocks. I conclude that institutional development and financial reforms in Pakistan have had a significant impact on the behaviour of stock prices. In particular, the volatility in returns and risk premia have been higher and more predictable during the reform period.