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The purpose of this paper is to examine the implications of stock market liberalization on cost of capital as one of the crucial driver to stock market development and physical investment growth in emerging Islamic countries.
This study employs static panel data techniques on the sample of seven emerging Islamic countries over the years The forex jubilant revenant emerald of this study suggest that stock market liberalization significantly reduces cost of capital in the stock markets of sample Islamic countries, which carries policy-oriented implications.
Reduction in the cost of capital increases the number of exchange-traded companies, profitability of projects and aggregate investment level; therefore, the study findings are highly concerned by the economic policymakers, corporations and investors alike.
In the literature, different proxies are employed to measure stock market liberalization and cost of capital as well. Due to data limitations, this study could not employ different proxies for both, especially for stock market liberalization, for robustness purpose, forex jubilant revenant emerald.
That limitation further restricted the coverage of Islamic stock markets and time period. Therefore, generalization of the study results for overall Islamic stock markets can be slightly drawn. The paper provides further understanding regarding the effects of SML on cost of forex jubilant revenant emerald, thereby indirectly on the stock market development, in the context of EIC.
İlhan, B. Copyright ©Bilal İlhan. Published in Journal of Capital Markets Studies, forex jubilant revenant emerald. Published by Emerald Publishing Limited.
This article is published under the Creative Commons Attribution CC BY 4. Anyone may reproduce, distribute, translate and create derivative works of this article for both commercial and non-commercial purposessubject to full attribution to the original publication and authors. Financial liberalization became an essential economic policy in order to transform the economic structure of developing countries into a state where both private sector and developed financial markets are the main drivers of the economic growth since the s Bekaert et al.
repatriation of dividends, investment returns, etc. Henry, a. The proponents of SML have advocated that it has positive implications on the economic growth, i. an increase in the market capitalization and liquidity Fuchs-Schündeln and Funke, ; and cost of capital, i. On the other hand, it is heavily criticized in forex jubilant revenant emerald literature that the very nature of pro-cyclical and irrational international financial capital, and incomplete capital markets with weak institutional and regulatory framework caused many crises in the emerging markets since s Singh, ; Krugman, ; Granger and Huang, ; Stiglitz, ; Prasad et al.
The divergence regarding the performance of stock market development among emerging markets has appeared since the mid of s. More specifically, while some emerging non-Islamic countries ENIC [1] on average have positively diverged from emerging countries, most of the emerging Islamic countries EIC [2] have not been able to perform at the same pace with regard to stock forex jubilant revenant emerald development.
These charts briefly indicate that the gap with regard to stock market development between EIC and ENIC has been increasing so far. The academic studies, such as Dewandaru et al. The stated common characteristics of these markets are small size, less liquidity, less efficiency, carrying higher risk premium, i. high cost of capital and volatility, and having poor quality of legal environment and governance, forex jubilant revenant emerald.
Even though the proponents of financial liberalization advocates that the fundamental problems that EIC have should be solved through the liberalization of domestic capital markets, the limited number of studies which partially covers the stock forex jubilant revenant emerald of EIC illustrate mixed results. For example, Achy examines the effect of domestic financial liberalization, i. the liberalization of interest rate, in the MENA countries including Egypt, Jordan, Morocco, Tunisia and Turkey over —, forex jubilant revenant emerald, and the results suggest that the private investment and economic growth are affected negatively.
Also, Gentzoglanis claims that the relationship between the degree of financial openness and economic growth is weak, forex jubilant revenant emerald not absent, in the MENA countries comparing to the developed countries over — Nevertheless, Naceur et al. Therefore, considering the forex jubilant revenant emerald inconclusive theoretical and empirical literature and shown divergence on the forex jubilant revenant emerald market development trends between EIC and ENIC, this study is motivated to ask the following research question: RQ1.
Does SML decrease the cost of capital, as one of the vital factor for stock market development, in the stock markets of EIC? Even though quite number of studies have been conducted with regard to the effect of SML on the stock market development, the empirical studies specifically focusing on EIC as the study sample is missing.
This study contributes to the current literature as follows: first, it provides further understanding regarding the effects of SML on cost of capital, thereby indirectly on the stock market development, in the context of EIC.
This is obtained by estimating the relationship between SML variable and cost of capital indicator, forex jubilant revenant emerald, i. dividend yield, in seven EIC over — Second, for robustness purpose, the variables, namely, crude oil price, interest and exchange rates are controlled in the same model.
At last, since the effects of SML are highly concerned by economic policymakers, corporate managers and investors, the study results carry policy-oriented implications.
For instance, a change in the cost of capital affects the number of public listed companies which can access to cheaper funds.
Finally, it affects forex jubilant revenant emerald valuation of companies. In a nutshell, a change in the cost of capital has fundamental consequences on the capital accumulation, investment, stock market development and economic growth. Overall, the empirical findings of the study suggest that SML is a highly significant explanatory variable in explaining the reduction on cost of capital, represented by dividend yield, in the stock markets of EIC.
The remainder of the paper is organized as follows. In Section 2theoretical background and literature review and the proxy selection for SML will be provided. In Section 3the description of sample data and variables, forex jubilant revenant emerald, the explanation of methodology used in the empirical analysis and the illustration of SML proxy construction will be provided. Section 4 outlines the main results accompanied with policy implications and Section 5 concludes the study.
Relying on capital asset pricing model CAPM and information asymmetry channel models, forex jubilant revenant emerald, the proponents of liberalization claim that SML decreases the cost of capital via its implications on both domestic market risk premium and pricing of information asymmetry [3].
In a world where all local capital markets are completely segmented from each other, the local investors must bear all risks of the economic activities of that country. Country risk would be incorporated in the expected rate of return, i. price of security, which is termed as market risk premium by investors. Under the assumption that investors consider only expected return of their investment, the variance of that return, i. σ domestic market return 2, forex jubilant revenant emerald.
As a result, forex jubilant revenant emerald, based on the assumption that all investors have same risk aversion, i. When investors evaluate the risk of a risky security, they do not consider the risk of that security alone.
Instead, they consider how this security contributes to the risk of their portfolio. β security. Therefore, the β of a portfolio is equal to the weighted average of β s within, forex jubilant revenant emerald. A security that adds more to market portfolio risk has a higher β. Since that security is riskier, it should have a higher risk premium. The risk premium on the world market portfolio, forex jubilant revenant emerald, i. World market risk premium, equals to the expected return of the world market portfolio, i.
In case all countries open their capital markets, forex jubilant revenant emerald, investors who consider only the expected return and the return variance of their portfolio tend to hold the global market portfolio to maximize diversification benefits Bekaert and Harvey, a. Therefore, investors can hold portfolios with a higher expected return for the same variance or with the same expected return for a lower variance, forex jubilant revenant emerald.
Therefore, due to the integration with world capital markets, SML decreases the domestic market risk premium under the following circumstances: with the condition forex jubilant revenant emerald the correlation between the volatility of domestic market portfolio and world market portfolio is positive and the latter does not exceed the former significantly, and.
with the condition that the volatility of world market portfolio is lower than the volatility of domestic market portfolio, irrespective of the correlation coefficient sign. The discount rate, i, forex jubilant revenant emerald. cost of capital, for a security price is calculated using Equation The security risk premium β security depends on its covariance with a market risk premium, as shown in Forex jubilant revenant emerald Hence, as SML reduces market risk premium, it will reduce the discount rate for that security as well.
There are three models suggesting that a reduction in the pricing of information asymmetry decreases the cost of capital due to various reasons, which are competition channel model CCMagency channel model ACM and financing constraint channel model FCC. Albeit it is suggested that the degree of information asymmetry has no separate effect on the cost of capital in the economies with perfect competition Lambert et al. These models suggest that when the number of investors is finite in an economy, each investor pushes the price upward or downward when he or she performs buying or selling transactions.
The CCM suggests that SML leads to a higher reduction in the pricing of information asymmetry with the condition that the number of uninformed investors is more than the number of informed investors in the imperfectly competitive economies where the financial markets regulated and supervised by opaque and poor-quality institutions. The model suggests that while an increase in the number of uninformed investors increases risk-bearing capacity via greater sharing of the adverse-selection risk, thereby reducing the pricing of information asymmetry; an increase in the number of informed investors increases the adverse-selection risk, hence causing an increase in the pricing of information asymmetry, forex jubilant revenant emerald.
Bae et al. This could be justified based on the argument that new foreign investors rely primarily on arms-length hard information, forex jubilant revenant emerald.
Hence, they are more likely to be uninformed relative to the domestic investors in the countries with opaque and poor-quality institutions. Contrary to the expectation of the CCM, the ACM argues that the decrease in the pricing of information asymmetry should be greater in the countries with high-quality institutions Balakrishnan et al.
The model elaborates the underlying rationale in a way that the informed foreign investors can rely on arms-length information of a domestic market only in the case the respective country has high quality and transparent institutions. Otherwise, it would not be possible for foreign investors to monitor firms effectively, forex jubilant revenant emerald.
Furthermore, as demonstrated by Myers and Majluf and Stiglitz and Weissthe cost of external fund is higher than that of the internal fund because of the existing information asymmetry between borrowers and lenders.
The wedge between the cost of internal and external fund causes firms to face constraints in the financial markets. The reason to that is financing constraints distort the inter-temporal substitution between investment today and investment tomorrow, hence forcing firms to postpone investment to future periods. Nevertheless, SML brings external financing sources to the domestic market, providing options to investors to materialize investment without further delay.
Nevertheless, the criticism against financial liberalization draws attentions to the point that the inefficient allocation of capital due to the speculative international capital flows may lead to distortions in the cost of capital.
Economists, such as BhagwatiRodrik and Stiglitzamong others, forex jubilant revenant emerald, argue that SML may generate speculative capital flows, which are not related to the fundamentals of companies or capital markets toward which they flow.
The principal reason behind this argument is that investors make decisions based on animal spirits, hence blindly follow the crowd rather than acting rationally, especially in the periods of massive capital flows. Financing economic growth via such portfolio investments renders economies sensitive to sudden inflows and outflows. These sudden and irrational capital flows cause destructions in the capital markets, and force countries to make dramatic macroeconomic adjustments, e.
a sharp increase in the interest rate or devaluation of local currencies. Consequently, SML may destabilize the overall economy. Therefore, SML does not always lower the cost of capital and facilitate capital flow to the firms and countries which have the best investment opportunities, i.
inefficient allocation of resource. This means the financial liberalization promotes neither investment nor economic growth, forex jubilant revenant emerald. It is generally accepted that SML is not a one-shot event, but a process; and not identical for forex jubilant revenant emerald emerging countries.
This is because they exhibit differences in the level of macroeconomic variables, development of financial infrastructure, and in prioritization the steps in liberalizing domestic capital markets. The oldest approach in measuring SML is to treat it as a one-shot event, which assumes that the domestic capital markets were completely segmented before and became perfectly liberalized after the official liberalization announcement date [5][6].
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