Empirical Results on market efficiency and its analysis
During the late 1990s, there existed several market frictions and phenomena unique in the Korean futures and stock markets that would hinder a quick adjustment of market prices to information. In order for futures trading to effectively reduce market frictions in the stock market, it is necessary that information created in the futures market be transmitted to the stock market freely and quickly. When futures trading introduce in Korea in 1996, several market regulations including daily price change limit such as “circuit breakers” and “sidecar system,” restrictions on foreign ownership of Korean stocks, and inactive program trading made it almost impossible to arbitrage between the futures market and the stock market.
First, circuit breakers were designed to reduce market volatility in the short run, and adopted in both Korean futures and stock markets. Since the introduction of futures trading on the KRX in 1996, circuit breakers were operated only one time in 1996 but 49 times each in 1997 (during the last two months of November and December) and 1998. Hence, circuit breakers were put in operation mostly after the IMF financial crisis in October 1997. The Period IV(post-options trading period) overlaps to a large extent with the IMF financial crisis period. Hence, circuit breakers appear to have been effective in reducing substantial market volatility resulting from the financial crisis during Period IV. On the other hand, as circuit breakers halt the regular trading process, it effectively restricts the production and smooth flow of information from futures market to stock market. As a consequence, circuit breakers seem to have restricted the trading efficiency of the underlying KOSPI 200 stocks, relative to non-KOSPI 200 stocks.
Second, another market regulation unique in the Korean market is the sidecar system. The sidecar system was introduced to the futures market on November 25, 1996. It was intended to stabilize spot market by minimizing possible impacts on the spot market from abrupt and large-scale price changes in the futures market. The sidecar system was operated three times for two days in 1996, but 120 times for 56 days in 1997 (during the last two months of November and December), and 183 times for 107 days in 1998, which suggests that sidecar system was put in place mostly to reduce market volatility associated with the IMF financial crisis. Similar to circuit breakers, this system, once operated, blocks an efficient transfer of futures market information into KOSPI 200 stocks in the spot market. Hence, the sidecar system appears to have hindered the efficient trading of KOSPI 200 stocks, while at the same time effectively decreasing spot price volatility.
Third, restrictions on foreign ownership in listed and public (government-affiliated) companies in Korea also seem to have contributed to the inefficiency of the market operation. There have been...