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Some tests of the efficacy of security regulation in Canadian capital markets Kryzanowski, Lawrence

Abstract

While most lawyers, government officials and security regulators would find it difficult to conceive of an efficient and equitable stock market without existing security regulation; a number of brokers, investors and economists would not find it difficult to do so. Although the merits of each viewpoint have been debated at length, the efficacy of security regulation in improving the efficiency of security markets has not been resolved empirically. Given this deficiency in the literature, the major purpose of this thesis has been to derive specific hypotheses from the two competing viewpoints and then to empirically test the predictions of each hypothesis on the effectiveness of trading suspensions in improving the strong form efficiency of Canadian stock markets. The two hypotheses are the naive regulator (NR) hypothesis, which states that an unregulated market is efficient, and the sophisticated regulator (SR) hypothesis, which states that an unregulated market is not efficient. The competing hypotheses were empirically tested using a sample of 120 Canadian stocks that had their trading suspended temporarily because of a failure to disseminate requested firm-specific information. Three subsamples of the 120 stocks (allegedly manipulated, unfavourable information and favourable information) were also identified .and analyzed. According to the strong form of the efficient market hypothesis (and it logical consequence, the NR hypothesis), the effect of any information dispersed during a trading suspension should be zero, since any information not "fully reflected" in current stock prices would not be available to the regulators. On the other hand, the SR hypothesis predicts that the effect may not be zero because information not "fully reflected" in current stock prices may be known to regulators. The market's response to new information, such as the "non-public" information supposedly disseminated during a trading suspension, was measured by the firm-specific component of a securities' return. The significance of this market response was then examined by using a number of tests, such as the Fama-Fisher-Jensen-Roll test, the portfolio test, parameter sensitivity tests and a pooled cross-section time series regression test. The study identified regulators as having access to significant monopolistic information which is disseminated to the market (the public) during a trading suspension. It also found that while the market is efficient in the semi-strong form for favourable new public information, such is not the case for unfavourable new public information. Furthermore, the findings of the study suggest that deliberately pursued strategies of disseminating (and exploiting) misinformation are profitable.

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