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HERDING AND TRADING VOLUME

Elsa Qingqing Lan Faculty of Business Administration University of Macau

Rose Neng Lai Department of Finance and Business Economics University of Macau

Rose Neng Lai (Contact Author) is Associate Professor, Department of Finance and Business Economics, University of Macau, Taipa, Macao SAR, China. E-mail: RoseLai@umac.mo. Tel. No.: (853)-8397-4728, Fax. No.: (853)-2883-8320.

Electronic copy available at: http://ssrn.com/abstract=1914208

HERDING AND TRADING VOLUME

Abstract: This study modifies the cross-sectional absolute deviation of returns (CSAD) of Chang, Cheng and Khoranas (2000) by adding trading volume variable and find significant evidence of herding in the Hong Kong stock market using daily data. Specifically, higher trading volume induces more herding. Moreover, while proven as a long-lived phenomenon, herding cannot generate positive market returns. On the other hand, positive market returns are the basis of herding. In addition, there is no evidence supporting the notion of cross-market herding information between the Hong Kong stock market and the Chinese stock market. However, the return information from one market will influence the herding behavior on another market. We add to the literature of herd behavior by introducing trading volume to explaining the CSAD.

Electronic copy available at: http://ssrn.com/abstract=1914208

1. Introduction People tend to follow others to make identical investment decision when there is less publicly available information. This well-known phenomenon is herding. Both investors and academic researchers have paid more attentions on herding in financial market over the recent past. Investors are interested in whether they can make profit by relying on collective information rather than private information. Academic researchers also care about herding since it causes prices to deviate from fundamental values. Existing literature has two kinds of views about herding, either rational or irrational. Devenow and Welch (1996) demonstrate that investors ignore their prior beliefs and follow others without any rational reason. On the other hand, according to Scharfstein and Stein (1990) managers do the same investment actions as others rationally, completely ignoring their own private information, in order to maintain reputation within the same evaluated peer group.

There is a common perception that herding behavior of growing institutional investors influences on market security prices, which causes excess risks and volatilities. Sias (2000) finds that institutional investors try to trade the same stocks. Wylie (2005) suggests UK mutual fund managers herd the largest and smallest individual stocks. Chan, Hwang and Mian (2005) verify that the reason behind the herding behavior of mutual fund managers is uncertain information. Voronkova and Bohl (2005) find that pension fund investors herd seriously in the Poland stock market.

Researchers have proved herding from both theoretical models and empirical studies. For theoretical models, Scharfstein and Stein (1990) provide reputational herding behavior model, Bikhchandani et al. (1992) give informational cascades model, while Banerjee (1992) has sequential model. For empirical studies, Lakonishok, Shleifer and Vishny (LSV) model of Lakonishok et al. (1992) and the cross-sectional absolute deviation of returns (CSAD) model of Chang, Cheng and Khorana (2000) are most
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Electronic copy available at: http://ssrn.com/abstract=1914208

commonly referred. Lakonishok et. al. (1992) propose the first methodology that has been subsequently widely used for empirical testing. They use LSV model to prove the potential herding effect of their trading on stock prices. Christie and Huang (1995) examine the herding behavior by utilizing the cross-sectional standard deviation of returns (CSSD) as a measure of the average proximity of individual asset returns to the realized market average in the US equity market. Chang, Cheng and Khorana (2000) extend the work of Christie and Huang (1995) by proposing a new and more powerful approach to detect herding based on equity return behavior, which is the CSAD.

This paper studies herding behavior in the Hong Kong stock market. As an international financial center, the Hong Kong stock market is dominated by institutional and foreign investors. Using daily data, Chang, et. al. (2000) find no evidence of herding in Hong Kong and partial evidence in Japan. However, Zhou and Lai (2009) modify the LSV model and found that Hong Kong does present herding behavior using intraday data. Specifically, herding is more popular with small stocks and in economic downturns; and investors are more likely to herd when selling rather than buying stocks. They argue that herding can be short-lived and exists in a certain industry, suggesting herding behavior is not persistent phenomenon.

The contradicting herding results related to the Hong Kong stock market motivate us to verify whether herding exists. The Hong Kong stock market is selected for several reasons. First, this is a market dominated by institutional and foreign investors. According to the Hong Kong Exchanges and Clearing Limited, 70% of investors are institutional investors, who have a tendency to herd because they want to maintain the reputation in the industry. For instance, Shiller and Pound (1989) show that big institutional investors place significant weight on the advice of other professionals related to their buying and selling decisions for more volatile stocks. Most of the rest 30% of individual investors tend to have less professional knowledge and less accurate information. They will therefore need to rely on others blindly without doing
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much investment evaluations. Both institutional and individual investors can cause herding in the market. For this reason, herding is expected to be present in the Hong Kong stock market.

Second, to the best of knowledge, there are only three empirical studies of herding behavior in the Hong Kong stock market. Chang, Cheng and Khorana (2000) analyze daily equally-weighted index returns data from January 1981 to December 1995 and find no significant evidence of herding in this market. However, Zhou and Lai (2009) prove herding behavior exists in the Hong Kong stock market using intraday data. Since the two studies use different sample periods, it is worthwhile to see whether the model of Chang, Cheng and Khorana (2000) can also be evidence to prove herding if more recent period in the Hong Kong stock market is used.

This study uses the cross-sectional absolute deviation of returns (CSAD) of Chang et. al. (2000) on daily data and examines herding behavior covering the more recent period from January 2006 to December 2010 when the 2008 Global Financial Crisis happened. We further extend the literature by adding trading volume to the model. We conjecture that higher trading volume facilitates more herding. Our results document significant evidence of herding in the Hong Kong stock market. This contradiction with that of Chang, et. al. (2000) and agreement with Zhou and Li (2009) may be due to a more diverse market because many new firms have been listed in the market since 2006. We perform the same test to the Shanghai Stock market as a comparison. We also test the up- and down-markets separately, and the result shows that herding is only significant in the down-market, which is consistent with the literature.

Our point of focus is that trading volume is one of the reasons to explain the herding behavior. We use vector autoregression (VAR) approach to find that herding cannot generate positive market returns. However, positive market returns are the potential basis for herding in the following period. In terms of stocks traded both in Hong Kong

and Shanghai, there is no apparent herding. 1 However, the return information from the Chinese stock market influences the herding behavior on the Hong Kong stock market, or vice versa. Finally, as in Christie and Huang (1995), herding appears to be more profound during the extreme economic environment. It should be noted that, by using daily data and showing herding is a prevalent phenomenon in Hong Kong, we can also conclude that it is also long-lived phenomenon.

This paper is organized as follows. Section 2 briefly describes the various herding models. Section 3 provides data description and methodology in details. Section 4 presents empirical results and the details of different testing results. Finally, section 5 concludes the study and proposes further research.

2. Models on Herding Research on herding can be dated back to Keynes who suggests in The General Theory of Employment, Interest and Money (Keynes, 1936) that some investors do the trading that may not be based on their own knowledge or preference. Instead, they often do the transaction following others since investors are afraid of making wrong decisions. Similarly, Shiller and Pound (1989) document that herding can be also important when the market is dominated by large institutional investors. Because institutional investors are evaluated with respect to the performance of a peer group, they pay significant attentions on the advice of other professionals when they buy and sell for more volatile stocks.

In fact, herding not only happens on the individual or institutional investors, but also exists in the daily life. Banerjee (1992) says that herding can be defined when people following other in making the same decisions. Cot and Sander (1997) defines herding as individual investors changing their own decision to follow the market in order to
Demirer and Kutan (2006) find that herd behavior does not exist in Chinese Shanghai and Shenzhen stock markets by using both individual firm- and sector-level data, which support rational asset pricing models and market efficiency. Tan et.al. (2008) report that herding behavior is significant under both up-and down-market conditions and is especially present in A-share stock market in China.
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reduce risk. Nofsinger and Sias (1999) suggest that investors herd when they have tendency to do the same investment during a specific period of time. Bikhchandani and Sharma (2000) prove that people do the opposite investment against their own decisions based on other investors information. Hwang and Salmon (2004) gives a more detailed definition that herding is caused by the change of market fundamental information.

Herding behavior can be either a rational or irrational form of investor behavior. Devenow and Welch (1996) focus on the irrational view and suggest investor make decisions ignored their prior preferences and follow other investors blindly. On the other hand, the rational view of herding behavior concentrates on the principal-agent problem in which managers do the same actions of others, completely ignoring their own private information in order to maintain their reputation in the stock market (Scharfstein and Stein, 1990).

Researchers commonly refer to two models to detect the presence of herding behavior in equity markets. One is to use trading volume or number of traders as the target, checking whether it is heavier than expected inclination toward one side of trading. A typical example is the LSV model. Another is to use stock returns as target to see whether it is consistent with the rational expectation. Theoretically, the level of equity return dispersions will increase when the absolute value of overall market returns increase since the volatility increase. However, if market participants tend to follow aggregate market behavior and ignore their own priors, then increasing linear relationship between return dispersions and market returns will no longer hold. Instead, the relation can become non-linearly increasing or even decreasing. If a stock return dispersion is close to zero, then the possibility of herding is larger. Examples are the CSSD model and CSAD model.

Cross-sectional Standard Deviation of Returns (CSSD) Model is suggested by Christie and Huang (1995) to test herding behavior in an extreme market condition. The CSSD measure is defined as,

CSSDt =

N i =1

( Ri ,t Rm,t ) 2 N 1
(1)

where R i,t is the observed stock returns on firm i at time t and R m,t is the cross-sectional average of the N returns in the aggregate market securities at time t. This dispersions measure the deviation of the average proximity of individual returns to the average. If individuals ignore their own beliefs and base their investment decisions only on the collective actions of the market or the fashion leader, security returns will not deviate too far from the overall market returns. This behavior will lead to dispersions increased at a decreasing rate. It may even observe a decrease in dispersions if herding is severe.

Christie and Huang (1995) suggest that individual investors are most likely to ignore their own information or preference during periods of extreme price movements. As a result, Christie and Huang suggests the model for extreme conditions, which is

CSSDt = + L DtL + U DtU + et

(2)

where DtL =1 if the market returns on day t lies in the extreme lower tail of the distribution, and equal to zero otherwise, and DtU =1 if the market returns on day t lies in the extreme upper tail of the distribution, and equal to zero otherwise.

Chang, Cheng and Khorana (2000) modify the CSSD to Cross-sectional Absolute Deviation of Returns (CSAD) Model. According to the rational asset pricing models, equity return dispersions should be an increasing linear function of the market returns. If market investors tend to follow aggregate market behavior and ignore their own priors during periods of extreme price movements, then the linear and increasing relation between dispersions and market returns will not hold. As a result, the
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relationship can become non-linearly increasing or even decreasing. Since this is the methodology used in this study, we will reserve the details for the following section. It should be noted that the CSSD model and CSAD model may provide conflicting results. First, CSSD model detects the herding behavior in the extreme situation. On the other hand, CSAD model is applied to the general market without requiring large volatility. It is this reason we choose CSAD to study the Hong Kong stock market. Second, the CSSD model requires a bigger magnitude of non-linearity in the relationship for evidence of herding than suggested by rational asset pricing models.

3. Data and Methodology Our study focuses on stocks selected from Hang Seng Composite Index (HSCI). HSCI is firstly introduced on October 3, 2001, and covers more than 200 constituent stocks, or 90 percent of the market capitalization listed on the main board 2. Our sample consists of daily stock price, trading volume, and HSCI data for the period of January 2006 - December 2010. The data includes 1236 trading days, covering all the constituent stocks.

For the Chinese stock market, Shanghai stock market 3 is selected to represent the main market since it is the largest stock exchange in mainland China. In China, local investors can trade A-shares. In contrast, the B-share market is dominated by foreign institutional investors. H-shares of Chinese companies have been traded in Hong Kong for many years. These equities have thus also been open to foreign investment. For this characteristic, it is interesting to examine the herding behavior of Hong Kong market due to the Chinese market. The study uses Shanghai Composite Index to proxy the market. The sample period is also from January 2006 to December 2011. There are totally 841 stocks in the sample period. Since two markets are under different

The Stock Exchange of Hong Kong (SEHK) consists of a Main Board and the Growth Enterprise Market (GEM). Stocks that fail to fulfill the profitability or track record requirements of the Main Board are listed on GEM.

Most of the total market cap of the Shanghai Stock Exchange is made up of formerly state-run companies like major commercial banks and insurance companies. Many of these companies have only been trading on the exchange since 2001.

regulations and the number of days for trading is not the same, in order to match two market data with the same dates, the trading day pattern in the Hong Kong market is used as reference. Hence, due to trading day difference, 35 trading days are affected, but is nevertheless negligible relative to the whole sample period (1236 days).

The daily logarithmic returns are calculated as,

= Ri ,t ln Pi ,t ln Pi ,t 1 = Rm,t ln Pm,t ln Pm,t 1

(3) (4)

where R i,t is the daily logarithmic returns for underlying asset i, P i,t is the price of underlying asset i, P m,t is market index, all measured at day t. These time series are normally distributed. Similarly, the daily logarithmic trading turnovers are

= Vol ln Vm,t ln Vm ,t 1 m ,t

(5)

where Vol m,t is the daily logarithmic turnover rate for underlying market m at day t. V m,,t is the trading volume divided by total number of share of the market at day t.

Following Chang, Cheng and Khorana (2000), the rational asset pricing models predict that the level of equity return dispersions will increase when the absolute value of overall market returns increase since the volatility increase. In other words, there is a positive linear relationship between CSAD and market returns. However, if market investors try to follow whole market behavior and ignore their own preferences during periods of large price movements, then the relationship between dispersions and market returns can increase in a decreasing rate, or even decreasing if herding is severe. To begin, let R i be the return on any asset i, R m be the return on the market index, and E t (.) denote the expectation in period t. A conditional version of the Black (1972) capital asset pricing model (CAPM) can be expressed as follows: Et ( Ri ) = 0 + i Et ( Rm 0 ) (6)

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where 0 is the return on the zero-beta portfolio, i is the time-invariant systematic risk measure of the security, i = 1, . . . , N and t = 1, . . . , T period. Also, let m be the systematic risk of an equally-weighted market portfolio,
m =
1 N

i =1

(7)

The absolute value of the deviation (AVD) of security i's expected return in period t from the t-th period portfolio expected returns is as following:

i m Et ( Rm 0 ) AVDi ,t =

(8)

Hence, the expected cross-sectional absolute deviation of stock returns (ECSAD) is


ECSADt = 1 N 1 N AVDi ,t = i m Et ( Rm 0 ) N i 1= N i1 =

(9)

The following functions shows the increasing and linear relationship between return dispersions and market expected returns,
ECSADt 1 = N Et ( Rm )

i =1

m > 0

(10)

2 ECSADt = 0 Et ( Rm ) 2

(11)

An alternative is to capture the non-linear relation between the market return dispersions and the market returns (see also Treynor and Mazuy (1966) which is
2 CSADt = + 1 Rm,t + 2 Rm ,t + t

(12)

CSAD t and R m,t are used to describe the unobservable ECSAD t and E t (R m,t, ). If market investors are more likely to herd, CSAD measure would be a less than proportional increase (or even decrease). If herding exists, the 2 coefficient will be negative.

The models of Christie and Huang (1995) and Gleason, et al. (2004) do not require to estimate the value of beta. This avoids the possible specification error associated with CAPM. Specifically, CSAD is calculated from

CSADt =

1 N

R
i =1

i ,t

Rm,t

(13)

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If herding behavior exists, investors will make decisions based on the collective actions of the market, and return dispersions will not deviate too far from the market returns. The presence of a significant negative 2 parameter is an indication of herding behavior in the model.

Moreover, modified versions of the model for up- versus down-market are
UP UP 2 CSADUP = + 1UP RUP +2 ( Rm ,t ) + t t m ,t
DOWN DOWN DOWN 2 CSAD DOWN ( Rm ) + t = + 1DOWN Rm +2 ,t ,t t

(14) (15)

where CSAD t is the average AVD t of each stock relative to the return of the market return, R m,t in period t, and R m,t up(R m,t Down) is the absolute value of an realized return of all available securities on day t when the market is up (down).

Finally, herding may be enhanced with high trading volume. Odean (1998a and 1998b) suggests that excess trading is considered to be an irrational investment behavior, which is probably because of the investors overconfidence. He and Wang (1995) suggest that the exogenous information, private or public, can generate excess trading volume. This phenomenon is accompanied by high volatility which can be reflected into the stock prices. According to Bikhchandani, Hirshleifer and Welch (1992), investors tend to follow the preceding individuals and ignore public or private information when herding. During periods of the larger market price movements, heavy trading volume is expected to be present when the market is extremely good or bad. Thus, it can be argued that if herding behavior exists, there should be a negative relationship between the market return dispersions (CSAD) and market trading volume squared. Hence, introducing trading volume, we have
2 2 CSADt = + 1 Rm,t + 2 Rm ,t + 3Volm ,t + t

(16)

where Vol m,t is the change of turnover at day t for the market, R m,t is the value of the realized market return on day t.

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4. Empirical Results 4.1 Descriptive Statistics The univariate statistics for daily mean returns and the CSAD of returns are reported in Table 1. The data covers 1236 trading days (January 2006- December 2010). The average daily market return is about 0.0414%, which converts to 10.99% annualized return. In general, Hong Kong stocks are less volatile compared to other Asian equity markets, with daily standard deviations of 1.9308%. The corresponding event dates for the daily returns and CSAD are also reported. The maximum and minimum value of the average daily returns are about 11.8066% (on 30/10/2008) and -12.2007% (on 27/10/2008) respectively. It is obvious that the largest increase or decline from 2006 to 2010 is the impact of the financial tsunami. The Hong Kong economy still stays good in the first half of 2008, but takes an abrupt turn after September when the global financial crisis intensified with the collapse of the Lehman Brothers (on 15/09/2008). Another Asian meltdown hits the markets on October 27, 2008. The Hong Kong market is down by about 12%, hitting the nearest low point. On that day, the Iceland stock market is down 90% from its top. The great global deleverage continues. Futures markets are increasing margin requirements. This is all happening while hedge funds and mutual funds are seeing record redemptions. October has so far shown both the best and the worst stock market. It all adds up to buy or sell by following others. The question is whether these buying or selling actions can form herding. One of the characteristics to determine herding is the negative relationship between the market returns and return dispersions.

The average CSAD is about 2.0070%. The standard deviation of CSAD is about 0.7021%. The two extreme situations with a maximum CSAD of 8.9094% (on 28/10/2008) when the market is up by 11.7585%, a minimum of CSAD of 0.9855% (on 10/12/2010) when the market is down by 0.02983% clearly show that herding is more obvious in the down-market since investors move in perfect unison with the market. As expected, CSAD is smaller when the investors do the same trading

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decision towards the market. On the other hand, when investors deviate far away from the market, the CSAD will be larger.

4.2 Herding Results Figure 2 plots the relationship between the CSAD and the corresponding market returns in the Hong Kong stock market. There is an obvious non-linearity between CSAD and the market returns. When the market returns is less than zero, there is a negative relationship with CSAD, a suspect for herding. When the market returns is greater than zero, CSAD increased positively. The regression result is
2 CSADt = 0.0008 + 0.0672 R m ,t 0.6659 Rm ,t + t

(3.84)***

(6.08)***

(7.52)***

(17)

It is obvious that the average level of equity return dispersions are about zero when R m,t equals to zero. It means that there is no systematic risk when the market portfolio does not exist, which makes economic sense. Furthermore, the coefficient on the linear term of R m,t is positively significant. The coefficient of R2 m,t is -0.6659 and negatively significant. In other words, CSAD increases at a decreasing rate as the average market returns become bigger in absolute value. The result does not support the predictions of rational capital asset pricing model which states that the level of equity return dispersions (CSAD) will increase when the absolute value of overall market returns increase since the volatilities increase. When the market returns increase, the volatilities also increase. The result therefore concludes that herding exists in the Hong Kong stock market.

Herding is normally more severe in markets with more different industries with sufficient stocks. This may be a reason why our results contradicts those of Chang, Cheng and Khorana (2000); their data covers 1981 through 1995, while many firms are listed between 1995 and 2010. Furthermore, Zhou and Lai (2009) argue that herding can be short-lived and exists in only certain industry by using intra-day data. However, our result proves that the herd behavior can be a general phenomenon by using daily data, which is persistent across days.
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The date is further separated into up- and down-markets to test for asymmetric herding behavior in market trends. Here we define the up-market when the daily market return is positive, and the down-market when daily market return is negative. The regression results are shown in Table 2. The result surprisingly shows that herding is insignificant in the up-market. As for the down-market, the result shows that herding exists; return dispersions do not deviate too far from the market return, implying severe herding is present.

A more challenging question to ask is what makes up-market and down-market different in the presence of herding? One of the important reasons can be as following: when the market is moving downward, investors, especially institutional investors, face pressure of making the wrong decision, and therefore will be careful about their investment decision since their performance will be evaluated among the same peer group. Even though they have some private information, they will choose to follow the market pace in order to reduce the risk of being worse than their competitors. As a result, they will try to maintain a portfolio return that mimics the market return. On the other hand, when the market is moving up, investors will pay less attention to others or the market. Most of them will choose risky stocks, such as small stocks, based on their own choices. Another possible reason may be disposition effect. According to disposition effect, investors are more likely to realize the gain and retain losing stocks when doing investments. When the market is good, almost everyone can earn in the market. Investors do the trading more frequently according to their preference or believe. When the market is bad, they are not likely to sell the stocks to realize the negative return. The pressure of herding will push them to follow the market action in order to avoid losing more.

One implication of the finding is that investors have different reaction attitude about the information in different situations. When the market is upward sloping, investors try to react quickly to the positive information. This information will then be
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immediately reflected on the stock price without any delay. In other words, investors rationally follow the asset pricing models, which make the market more efficient. However, when the market is downward sloping, investors adjust to the negative news with a possibility of the delay. Without trading with negative news quickly, they will make decisions based on others so as to minimize loss.

4.3 Herding and Trading Volume The regression is estimated as following,


2 2 CSADt = 0.0006 + 0.0692 R m ,t 0.6797 Rm ,t 0.0026Volm ,t + t

(3.11)***

(6.26)***

(7.68)***

(2.81)***

(18)

The regression result shows that the effect from trading volume is as predicted. All the parameters are significant at 1%. The test result suggests that the trading volume contains incremental information in the market, which can explain herding behavior in Hong Kong. Investors believe that following others or market for the same decision can reduce risks, at least they follow the market.

The regression result is shown in Table 3. For comparison purpose, the simple CSAD model is also shown. After adding the turnover variable, the level of significance for both market return variable and market return squared term have increased. The adjusted R2 also increases slightly. The most important thing is that the turnover variable is also negatively significant, suggesting that the new model is better to describe the herding behavior.

The modified model can also conclude that trading volume can be one of the reasons to explain the herding behavior at least in the case of Hong Kong. High trading volume means the market is more liquid and contains more information. The liquidity-oriented investors can benefit from the liquid market if they need to follow others. Investors can realize the returns more quickly with more liquid market. As a result, investors are more likely to herd in liquid markets. On the other hand, individual investors do not have enough information. Under certain situations, these
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investors believe other investors may have first-hand information to trade. In order to reduce the costs and risks, they will follow others without doing much evaluation on the stocks. Both of the cases will cause high trading volume, and finally herding can exist in the market.

4.4 Power of Market Returns Generating Herding One interesting question is whether herding can generate positive returns (why else do people herd?). The econometric model of the vector autoregression (VAR) approach proposed by Sims (1980) is used. This model is considered as a good method to describe the relationships among different variables. All the variables in a VAR model are its own lags and the lags of all the other variables. According to this characteristic, Sims (1980) suggests using VAR models as a theory-free method to estimate economic relationships between multiple time series. In our case, the model becomes
Rm,t = + j CSADt j + j Rm ,t j + t CSADt = + j CSADt j + j Rm ,t j + t
p p p p

= j 1= j 1

(19)

j 1= j 1 =

(20)

where subscript j is the lag day, other variable keep the same as previous models.

The relationship is considered in two aspects: herding effect on market returns and market returns effect on herding. First, according to the expectations, investors herd because they believe others should know more information. As a result, herding can generate positive returns. Therefore, there is a positive relationship between lagged herding variable and market returns. However, investors can be informed or uninformed investors. Informed investors are usually speculators with information and knowledge. They follow others in order to maximize the portfolio returns. On the other hand, uninformed investors, mostly individual investors with limited resources, cannot have the same returns as the speculators since the investment time is not the same. Individual investors always herd after the speculators, in which case, they may buy at high price and sell at low price (speculators buy low and sell high). Normally,
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Pareto principle (also known as the 80-20 rule) proves that about 20% of the causes come from 80% of the effects in most of cases. This implies that there are eighty percent of investors who lose money while only twenty percent of investors who gain. In Hong Kong, since thirty percent of investors are individual investors, herding may not generate significant positive returns.

On the other hand, it is also interesting to see whether higher market returns can generate herding. When the market is good, everyone wants to share the profit, and thus positive market returns can generate more herding, which indicates positive relationship between lagged-market returns and herding behavior. Thus, following equations (19) and (20), j > 0 in function (19) implies herding cannot generate positive returns, while j < 0 in function (20), implies positive returns can push herding.

The test results are summarized in Table 4. The most recent three days are used to test. As expected, 1 to 3 are positive significant in Model A, suggesting that more herding (smaller CSAD) in the current period will generate less market returns in the next period. Both 1 to 3 are less than 1, suggesting that 1% decrease in CSAD will cause less than 1% decrease in market returns. When CSAD is small, the levels of return dispersions will be lower, which means the level of herding will be also higher. In this case, market return in the next period will be also small since there is a negative (positive) relationship between herding (CSAD) and next-period market returns. The main reason is that many individual investors lacking information and knowledge in the market will follow other investors blindly and believe they can earn just like other speculators. Alternatively, they believe other investors may have some private information. Unfortunately, they participate into the market when informed traders have already earned, when the information has already reflected into the stock price. So, individual investors always buy high and sell low. Some investors even do not want to realize the loss, which may cause another behavior called disposition effect. As a result, individual investors can be frequent losers in the stock market. The
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result is significant for the previous three periods. The previous two-period is the most significant.

The effect of herding on market returns is also tested. The parameters ( 1 to 3 ) of herding for the previous three days are always negatively significant. The value is diminished with the previous time, meaning that todays herding can be mostly explained by yesterdays return. Therefore, a positive (negative) relationship between herding (CSAD) and market returns is observed. In other words, positive market returns can generate high level of herding.

To conclude, herding cannot generate positive market returns. However, positive market returns are the basis of herding.

4.5 Lead-Lag Effect The Chinese stock market provides an interesting target for the analysis of investor herding behavior. Two classes of shares which are A-shares and B-shares have been issued since the establishment of the Shanghai Stock Exchange (SHSE) and the Shenzhen Stock Exchange (SZSE) in December 1990. Only domestic Chinese investors can buy A-shares, which are denominated in the local currency, the Renminbi (RMB). Before February 2001, only foreign investors can purchase B-shares. However, both foreign and domestic investors have bought B-shares since 2001. A-shares and B-shares are traded simultaneously on the Shanghai and Shenzhen stock markets. However, the characteristics of investors who invest in A-shares and B-shares are very different. The domestic individual investors who invest in A-shares are typically lack professional knowledge and experience in investments. In contrast, foreign institutional investors who invest in B-shares tend to be more professional and sophisticated. As a result, it is more likely that A-shares market is easy to perform herding behavior.

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On the other hand, H-shares are listed on the Hong Kong Stock Exchange. They are available mainly to non-Chinese mainland investors. The example is qualified domestic institutional investors (QDII). It is a scheme related to the capital markets to allow financial institutions to invest in offshore markets such as securities and bonds. In reality, international investors find it difficult to invest in the Mainland Chinese security market (especially, A-share market) directly due to lots of barriers. H-shares provide opportunities for Hong Kong and international investors to invest in Chinese stocks easily.

It is therefore interesting to examine whether H-share investors make their investment based on A-share investors decisions, or vice versa. By looking at the market indexes in Figure 3, Hang Seng composite index has a similar trend as Shanghai composite index. The univariate statistics for daily mean returns and the CSAD of returns in Shanghai stock market are reported in Table 5.The average daily market return is about 0.0715% (19.74% yearly) with relatively high standard deviation of 2.0534%. The highest daily market return is about 9.0345% (on 19/09/2008) which is quite abnormal for the whole market since the limit move is ten percent in a day in China. The extreme situation is also caused by financial tsunami. The lowest market return is about -9.2561% (on 27/02/2007). Global stock markets suffer a black Tuesday on that day. Most of stock markets in the world fall down a lot. The decline of Chinese A-shares is the first in the world. Then, its impact spreads all over the world. At that time, bubble also exists in the Chinese stock market. The average mean of CSAD series is about 2.0083% and the standard deviation is 0.8667%. However, the lowest CSAD is 0.9352 % (on 17/03/2010), suggesting most of stocks are moving together with each other. The mean and standard deviation for both market returns and CSAD are considered relatively high since the market is not very mature. The non-linear relationship between market returns and CSAD is also obvious in Figure 4.

20

Using the same regression model above, results on herding behavior in Shanghai stock market is as follows
2 0.0146 + 0.4496 R cn ,m ,t 4.2650 Rcn CSAD = cn , m ,t , m ,t + t

(38.19)***

(13.81)***

(7.16)***

(21)

Again, significant herding effect can be observed. Compared to the Hong Kong stock market, herding behavior of Shanghai is more significant since the parameter of 2 is more negative, which is -4.2654.

As a leading economy in the world, the Chinese market indisputably has influence to the other stock markets, especially Hong Kong market where stocks of the companies are dually traded. Therefore, it would be interesting to see how herding behavior is affected by Chinese market conditions. We choose stocks from Shanghai stock market to link with the Hong Kong stock market since it is Asias second largest stock exchange by market capitalization, behind the Tokyo Stock Exchange.

By incorporating the Chinese-CSAD, Chinese absolute market returns, and Chinese market return squared terms into equation (18), the modified model is as following,
2 2 2 CSAD hk ,t = + 1 Rhk ,m,t + 2 Rhk , m ,t + 3Volhk , m ,t + 4CSADcn , m ,t 1 + 5 Rcn , m ,t 1 + 6 Rcn , m ,t 1 + t

(22) Since the rational asset pricing model may not hold in detecting herding behavior, the variable of absolute value of Chinese market returns will not be included in the following models,
2 2 2 CSAD hk ,t = + 1 Rhk ,m,t + 2 Rhk , m ,t + 3Volhk , m ,t + 4CSADcn , m ,t 1 + 6 Rcn , m ,t 1 + t

(23)

Even if two CSAD are not related to each other, the Chinese market return may still be related to the herding behavior in Hong Kong. Therefore, we have
2 2 2 CSAD hk ,t = + 1 Rhk ,m,t + 2 Rhk , m ,t + 3Volhk , m ,t + 6 Rcn , m ,t 1 + t

(24)

where the subscript cn and hk in the models refers to the Chinese and Hong Kong respectively. All of the other variables are the same as defined earlier.

21

The reverse effect is also done with the following equations,


2 2 2 CSADcn ,t = + 1 Rcn,m,t + 2 Rcn , m ,t + 3Volhk , m ,t 1 + 4CSADhk , m ,t 1 + 5 Rhk , m ,t 1 + 6 Rhk , m ,t 1 + t

(25)
2 2 2 + 1 Rcn ,m,t + 2 Rcn CSADcn ,t = , m ,t + 3Volhk , m ,t 1 + 4CSADhk , m ,t 1 + 6 Rhk , m ,t 1 + t 2 2 + 1 Rcn ,m,t + 2 Rcn CSADcn ,t = , m ,t + 6 Rhk , m ,t 1 + t

(26) (27)

Table 6 reports the estimation results of the cross-market effect. In panel A, for all three estimations, 2 is negatively significant, that is, herding exists. However, 4 is not significant at all. In other words, the co-movements of cross-sectional return dispersions in two different markets cannot be observed even though some companies are listed in both markets. One possible reason for interpretation is that the market environment and characteristic of investors are different. As mentioned before, the A-share market is dominated by domestic individual investors who typically lack significant knowledge and experience in investments. In contrast, H-share market is available mainly to non-Chinese mainland investors. These two kinds of investors have different investment strategies towards the same stocks in different markets. Even both markets have herding, stocks in different industries can be herded in different markets. Compared to Chinese stock market, individual investors in Hong Kong may be more confident with herding information they get instead of relying on herding information from the Chinese stock market.

Moreover, the significantly positive coefficient of R cn,m,t-1 2 means that the return information from the Chinese stock market will lower down herding behavior in the Hong Kong stock market. Return dispersions increase as investors receive cross-market return information between the Hong Kong stock market and the Chinese stock market.

In Panel B, the herding effect of the Hong Kong stock market on Chinese stock market is reported. The result is similar. First, for all three estimations, 2 is
22

negatively significant, suggesting herding exists. Second, 4 is not significant. There is no statistical evidence to support that two markets have similar or opposite trends of herding behavior. Lastly, 6 is positive significant with the value less than one. So, the information in the Hong Kong stock returns has significant impact on the herding behavior in China. As a result, the study concludes that herding effect of two markets is independent. However, the return information from one market will influence the herding behavior on another market.

4.6 The Impact of Financial Tsunami The global financial crisis really starts to show its impact from the middle of 2008 to the end of the year. We chose this half year as the sample period to test the effect on the crisis. Christie and Huang (1995) verify that herding behavior is more profound in the extreme economic conditions in the Asian Financial Crisis. Choe, Kho and Stulz (1999) do the sub-period tests of foreign investors herding behavior during the Asian Financial Crisis in the Korean stock market and find that herding tends to be weaker during the crisis. They cannot find significant evidence to support foreign investors destabilize the Koreas stock market over the sample period. In other words, large sales by foreign investors are reflected quickly and efficiently on the stock prices in the Koreas stock market. Then, Ghysels and Seon (2005) suggest that herding behavior exists in index futures trading during the Asian Financial Crisis, which destabilize the Koreas stock market. Bowe and Domuta (2004) compare the herding behavior of foreign investors and domestic investors and conclude foreign investors herd more in the Indonesian market during the Asian Financial Crisis.

By adding the dummy variable to highlight the financial crisis, we modify the models as
2 2 2 CSADt = + 1 Rm,t + 2 Rm ,t + 3Volm ,t + 4 Rm ,t * Dt + t 2 2 2 2 CSADt = + 1 Rm,t + 2 Rm ,t + 3Volm ,t + 4 Rm ,t * Dt + 5Volm ,t * Dt + t

(28) (29)

23

2 2 2 CSADt = + 1 Rm,t + 2 Rm ,t + 3Volm ,t + 5Volm ,t * Dt + t

(30)

where D t takes value of unity during the financial tsunami from June 1, 2008 to December 30, 2008, and zero otherwise. The results are summarized in Table 7. First, all coefficients on R m,t , R m,t 2, and Vol m,t 2 are still highly significant. In particular, the coefficient values are consistent with those from expression (18). This suggests that market volatilities reflecting onR m,t , R m,t 2, and Vol m,t 2 are significant factors to explain market return dispersions. Second, the dummies for crisis are insignificant. The results suggest that the herding behavior is not significantly influenced by the Global Financial Crisis. On the other hand, trading volume is negative significant with the market return dispersions. In other words, high trading volume can increase high liquidity in the market, which could cause herding behavior, even in a crisis. However, t is not because of more reaction to returns during the crisis period, but the sensitivity to the trading volume that matters. Dropping the R m,t 2*D t still generates the same result. Therefore, we can safely conclude that herding can be explained by financial tsunami through its effect on trading volume.

24

5. Conclusion This study examines herding in the Hong Kong stock market. We modify the cross-sectional absolute deviation of returns (CSAD) of Chang, Cheng and Khoranas (2000) as a measure of herding by adding trading volume as an explanatory variable. The empirical tests indicate that equity return dispersions actually tend to increase at a decreasing rate, providing evidence of presence of herd behavior in the Hong Kong stock market as well as Chinese stock market. Compared to the prior literature, one of the possible reason of herding exists in recent years is that market needs sufficient equity in order to provide more choice for investors.

We use daily data and find that herding is a long-lived phenomenon in Hong Kong. Furthermore, herding is only present in the down-market. The result is consistent with the characteristic of the Hong Kong stock market which the market is dominated by the institutional investors, who try to reduce the risk by following investment decision of other professionals in order to maintain the reputation in the peer group. More importantly, we find evidence that trading volume plays an important role in explaining herding behavior. Furthermore, using, vector autoregression (VAR) approach to capture the relationship between herding and the market returns, the result suggests that herding cannot cause the positive next period market returns. On the other hand, positive market returns can generate the next period herding. We also find no evidence supporting that the return dispersions decrease as investors receive cross-market herding information between the Hong Kong stock market and Chinese stock market. We suspect that this is because the characteristic of investors are quite different in two markets. On the other hand, the information, private or public, from one market will influence the herding behavior on another market. Finally, herding appears to be more profound during the extreme economic environment.

25

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Figure 1

The general quadratic relationship between CSAD t and R m,t

CSADt

Rm,t* = - ( 1 / 2 2 )

2 CSADt = + 1 Rm,t + 2 Rm ,t

Rm,t

Note: A negative 2 parameter is an indication of herding behavior. When R m,t * = -( 1 /2 2 ), the quadratic function suggests that CSAD t gets its maximum point. In other words, as R m,t become larger, CSAD t is trending up (down) over the range where average daily returns are less (greater) than R m,t *. U in the CSSD model will never be negative unless some of the R m,t values during periods of market stress fall in the region where CSAD t is trending down.

32

Figure 2 Relationship between the daily cross-sectional absolute deviations (CSAD t ) and market returns (R m,t )

0.09

Cross-sectional Absolute Deviation

0.08 0.07 0.06 0.05 0.04 0.03 0.02 0.01 0 -0.1 -0.05 0 Market Return 0.05 0.1 0.15

33

Figure 3 Hang Seng and Shanghai Composite Index from January 2006 to December 2010

Figure 3a Hang Seng Composite Index from January 2006 to December 2010

Figure 3b Shanghai Composite Index from January 2006 to December 2010

34

Figure 4 Relationship between the daily cross-sectional absolute deviations (CSAD t ) and the corresponding market returns (R m,t ), Shanghai stock market (January 2006-December 2010)
0.09 0.08

Cross-sectional Absolute Deviation

0.07 0.06 0.05 0.04 0.03 0.02 0.01 0 -0.1

-0.08

-0.06

-0.04

-0.02 0 0.02 Market Return

0.04

0.06

0.08

0.1

35

Table 1 Statistics of market returns (R m,t ) and cross-sectional absolute deviations (CSAD t ) in the Hong Kong stock market R m,t Mean (%) S.D. (%) Maximum (%) Minimum (%) 0.0414 1.9308 11.8066 -12.2007 CSAD t 2.0070 0.7021 8.9094 0.9855

Note: This table lists descriptive statistics of daily market returns and cross-sectional absolute deviations (CSAD t ) for HK. The data covers 1236 trading day (January 2006December 2010). Calculations of CSAD are given by equation (16).

Table 2 Regression result relative to the up- and down- market Up-market Constant R m,t R2 m,t Adj-R2 0.00007 (0.24) -0.0127 (-0.62) 1.0830 (4.48) 0.1032 Down-market -0.0006 (-2.35) 0.0329 (2.35) -0.6690 (-7.02) 0.1370

Note: This table reports asymmetric herding behavior in market trends. Up-market is defined when the daily market return is positive, and the down-market as to daily market return is negative.

Table 3 Regression of the daily cross-sectional absolute deviations on market returns and turnover Model A Constant -0.0008 (-3.84)*** Model B -0.0006 (-3.11)*** 0.0692 (6.26)*** -0.6797 (-7.68)*** -0.0026 (-2.81)*** 0.0478 21.62*** R m,t 0.0672 (6.08)*** R
2 m,t

Test Vol
2 m,t

Adj-R

F-Value 28.35***

-0.6659 (-7.52)***

0.0424

Note: *The coefficient is significant at the 10% level. **The coefficient is significant at the 5% level. ***The coefficient is significant at the 1% level.
36

Table 4 Relationship between herding behavior and market returns Models/Variables CSAD t-1 CSAD t-2 CSAD t-3 R m,t-1 R m,t-2 R m,t-3 Adj-R2 Model A 0.4999 (3.04)
***

Model B -0.4527 (-15.44)*** -0.2294 (-7.27)*** -0.0322 (-1.09) -0.0287 (-5.64)*** -0.0145 (-2.48)** -0.0111 (-2.16)** 0.2178

0.9516 (5.38)*** 0.4893 (2.96)


***

-0.7685 (-26.93)
***

-0.5009 (-15.26)*** -0.2511 (-8,75)*** 0.3783

Note: *The coefficient is significant at the 10% level. **The coefficient is significant at the 5% level. ***The coefficient is significant at the 1% level. Table 5 Statistics of market return (R m,t ) and cross-sectional absolute deviations (CSAD t ) in Shanghai stock market R m,t Mean (%) S.D. (%) Maximum (%) Minimum (%) 0.0715 2.0534 9.0345 -9.2561 CSAD t 2.0083 0.8667 8.0303 0.9352

37

Table 6 Regression results of herding behavior and cross-market Panel A China leads HK Constant Model A -0.0006 (01/2006-12/2011) (-1.72)* Model B -0.0006 (-1.80)* Model C -0.0007 (-3.82)*** 0.0632 (5.72)*** -0.6979 (-7.94)*** -0.0026 (-2.87)*** 0.6544 (4.61)*** 0.0632 0.0638 (5.76)*** -0.6998 (-7.96)*** -0.0026 (-2.88)*** -0.0101 (-0.68) 0.6845 (4.6)*** 0.0628 0.0641 (5.75)*** -0.7014 (-7.96)*** -0.0027 (-2.88)*** -0.0086 (-0.54) -0.0056 (-0.26) 0.7626 (2.25) 0.0621 R hk,m,t R2 hk,m,t Vol2 hk,m,t CSAD cn,m,t-1 R cn,m,t-1 R2 cn,m,t-1 Adj-R2

Note: *The coefficient is significant at the 10% level. **The coefficient is significant at the 5% level. ***The coefficient is significant at the 1% level.

38

Table 6 Regression results of herding behavior and cross-market (continued)

Panel B HK leads China

Constant Model D 0.0140

R cn,m,t

R2 cn,m,t

Vol2 hk,m,t-1

CSAD hk,,m,t-1

R hk,m,t-1

R2 hk,m,t-1

Adj-R2

0.4859 (13.39)***

-4.1778 (-7.03)***

-0.0005 (-0.28)

-0.0056 (-0.11)

0.0504 (2.5) **

-0.1379 (-0.85)

0.2297

(01/2006-12/2011)

(30.29)*** Model E 0.0146 (36.80)*** Model F 0.01456 (37.92)***

0.4930 (13.60)***

-4.2191 (-7.08)***

-0.0001 (-0.09)

0.0168 (0.34)

0.2003 (2.26)**

0.2264

0.4933 (13.64)***

-4.2257 (-7.11)***

0.1966 (2.24)**

0.2276

Note: *The coefficient is significant at the 10% level. **The coefficient is significant at the 5% level. ***The coefficient is significant at the 1% level.

39

Table 7 Regression results of herding behavior in the financial tsunami

Country (sample period) Hong Kong (01/2006-12/2011)

Constant Model A -0.0006 (-3.03)*** Model B -0.0007 (-3.34) *** Model C -0.0007 (-3.23) ***

R m,t

R2 m,t

Vol2 m,t

R2 m,t *D t

Vol2 m,t *D t

Adj-R2

F-Value

0.0679 (5.14) ***

-0.6362 (-2.37) **

-0.0026 (-2.81) ***

-0.0371 (-0.17)

0.0470

16.21

0.0826 (5.89) ***

-0.9392 (-3.29) ***

-0.0020 (-2.14) **

0.2014 (0.88)

-0.0104 (-3.07) ***

0.0535

14.95

0.0752 (6.71) ***

-0.7012 (-7.93) ***

-0.0021 (-2.21) **

-0.0094 (-2.95) ***

0.0537

18.49

Note: *The coefficient is significant at the 10% level. **The coefficient is significant at the 5% level. ***The coefficient is significant at the 1% level.

40