Effect of regulation, Islamic law and noise traders on the Saudi stock market

Abstract

Saudi stock market (SSM) has witnessed various market regulations and transformations taking place over the past decade. However, the impact of these reforms on market efficiency has not been addressed in the literature. Furthermore, idiosyncratic features of the market can play an important role on the market performance, yet these features have not been fully investigated. The aim of this thesis is to tackle these issues by empirically examining the market efficiency hypothesis and volatility behaviour of the Saudi stock market. Specifically, in order to better understand the relationship between stock returns and prohibition of interest (riba), both conditional and unconditional volatilities are investigated in the context of Islamic law and herd behaviour of noise traders. In Chapter 2 the efficient market hypothesis is tested on the basis of various market efficiency models. Results of both parametric and non-parametric tests reveal that despite the evidence of improved efficiency in the Saudi stock market the weak form of efficient market hypothesis theory is still generally rejected. Chapter 3 considers two types of the generalised autoregressive conditional heteroscedasticity (GARCH) model, a univariate and multivariate GARCH. Specifically, the univariate GARCH model is used to test the seasonality effect of the Ramadan month on each of the five stock market sectors. The multivariate GARCH is used instead to investigate the effect of interest (riba) prohibition in Islam on the volatility of the Saudi stock market. A distinction is made between stocks that are in agreement with Islamic Sharia’a law and interest paying stocks that are not allowed to devoted Muslim investors. The result demonstrates that the Islamic compliant sectors are more volatile than non-Islamic compliant ones. Further, Ramadan seasonality is more significant for non-Islamic compliant stocks. Chapter 4 investigates market inefficiency by considering two anomalies: investors’ herd behaviour and structural breaks in the Saudi stock market. The herd behaviour is investigated by estimating a nonlinear asymmetric cross-sectional absolute deviation model, whereas structural shifts are modelled by estimating a Markov regime switching model. The volatility models considered confirm that both Islamic law and immature behaviour of investors are important factors that contribute to informational imperfectness in the Saudi stock market.