Stock prices and macroeconomic variables MDE thesis

ii
UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES
HO CHI MINH CITY THE HAGUE
VIETNAM NETHERLANDS
======o0o======

VIETNAM – NETHERLANDS
PROJECT FOR M.A IN DEVELOPING ECONOMICS




STOCK PRICES AND
MACROECONOMIC VARIABLES IN
VIETNAM: AN EMPIRICAL ANALYSIS


BY
NGUYEN THI BAO KHUYEN

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

HO CHI MINH CITY, 2010



iii
UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES
HO CHI MINH CITY THE HAGUE
VIETNAM NETHERLANDS
======o0o======

VIETNAM – NETHERLANDS
PROJECT FOR M.A IN DEVELOPING ECONOMICS




STOCK PRICES AND
MACROECONOMIC VARIABLES IN
VIETNAM: AN EMPIRICAL ANALYSIS


A THESIS PRESENTED BY
NGUYEN THI BAO KHUYEN

IN PARTIAL FULFILMENT OF THE REQUIREMENT FOR THE
DEGREE OF MASTER OF ARTS IN DEVELOPMENT ECONOMICS

SUPERVISOR

Prof. Dr. NGUYEN TRONG HOAI




HO CHI MINH CITY, 2010



iv
DECLARATION


I certify that this thesis has been written by me, that it is the record of work
carried out by me and that it has not been submitted elsewhere.

HCMC, January 10, 2010


NGUYEN THI BAO KHUYEN




v

ACKNOWLEDGEMENTS

IT IS A TREAT to have an opportunity to formally express my appreciation to
people who have really created the concepts and methodology expressed in this

research.
I own the greatest debt to professors of MDE Programme, executive programme
administrations in Vietnam and colleagues. Their enthusiasm about the
experience and what they were teaching, was an important motivator for me.
I would like to express my deep and sincere gratitude to my supervisor,
Professor, Doctor Nguyen Trong Hoai, Dean of the Faculty of Development
Economics, University of Economics, Ho Chi Minh City. His wide knowledge
and his logical way of thinking have been of great value for me. His
understanding, encouraging and personal guidance have provided a good basis
for the present thesis.
I especially appreciate the VietFund Management colleagues, who have been
eager supporters of the research.

NGUYEN THI BAO KHUYEN
March 2010






vi
ABSTRACT
The article employs the cointegration and error correction version of Granger causality
tests to investigate whether the Vietnamese stock market exhibits the publicly
informational efficiency. The test results strongly suggest informational inefficiency in
the Vietnamese stock market. Specifically, the results from bivariate analysis suggest
that the Vietnamese stock market is not informationally efficient in both short- and
long-run. In addition, the stock market seems to even divorce from the most part of the
economy. Therefore, it is still possible for a “professional” trader to make abnormal

returns by analyzing good or bad news contained in some macroeconomic variables.
The findings re-assure that the Vietnamese stock market is not well functioning in
scarce resource allocation and not attractive enough to encourage foreign investors.
Since the market is not informationally efficient, especially with respect to monetary
variables, it may be dangerous for policy makers to realize the role of monetary
policies, the so-called demand stimulus packages. In terms of the investors‟ point of
view, fundamental analysis is still significant for their investment decisions. Thus,
companies with strong equity analysts would have higher comparative advantages in
this inefficient market. Furthermore, instead of becoming more efficient over time, as
one might expect, the Vietnamese stock market appears to have become increasingly
divorced from reality. This also reveals that the last financial crisis has serious impact
on the Vietnamese stock market.



vii
TABLE OF CONTENTS


CHAPTER 1 1
INTRODUCTION 1
1.1 RESEARCH CONTEXT 1
1.2 THE PROBLEM STATEMENT 2
1.3 THE RESEARCH OBJECTIVES 3
1.4 RESEARCH QUESTIONS AND HYPOTHESES 4
1.5 RESEARCH METHODOLOGY 5
1.6 STRUCTURE OF THE THESIS 5
CHAPTER 2 6
LITERATURE REVIEW 6
2.1 THE CONCEPT OF EFFICIENT MARKET 6

2.2 FORMS OF MARKET EFFICIENCY 7
2.3 MARKET EFFICIENCY AND VALUATION 12
2.4 THE DETERMINANTS OF STOCK PRICES 13
2.4.1 The Determinants of True Value 13
2.4.2 The Determinants of Stock Price 17
2.5 EMPIRICAL STUDIES 20
CHAPTER 3 24
RESEARCH METHODOLOGY 24
3.1 STATIONARITY AND UNIT-ROOT TESTS 24
3.2 VECTOR AUTOGRESSIVE MODELS AND CAUSALITY TESTS 25
3.2.1 VAR Models 25
3.2.2 Granger Causality Tests 26



viii
3.3 SEMI-STRONG FORM EFFICIENCY TESTS 28
3.4 ERROR CORRECTION MODELS 29
3.4.1 Cointegration 30
3.4.2 Error Correction Mechanism 30
3.4.3 Testing for Cointegration and ECM 32
3.4.4 ECM and Long-Run Efficiency 33
3.5 DATA COLLECTION AND ANALYSIS 35
CHAPTER 4 38
RESEARCH RESULTS 38
4.1 DESCRIPTIVE STATISTICS 38
4.2 BIVARIATE CAUSALITY TESTS 42
4.3 MULTIVARIATE GRANGER TESTS 48
CHAPTER 5 54
CONCLUSION AND POLICY RECOMMENDATIONS 54

5.1 MAIN FINDINGS 54
5.2 POLICY IMPLICATIONS 55
5.3 FURTHER STUDIES 57
REFERENCES 58




1
CHAPTER 1
INTRODUCTION
This chapter will explain why the efficient market hypothesis is worth
investigating in the case of the Vietnamese stock market. In particular, this
chapter is divided into six sections. The first section will provide evidence that
tells us why information becomes an issue of concern for the most part of market
participants and policy makers as well. From this background information, the
second section will raise the problem necessary to make clear for the case of
Vietnam. The third section will set four main objectives the thesis expects to
obtain in order to solve the research problem. To obtain the proposed objectives,
the fourth section will raise questions and corresponding hypotheses which direct
the whole thesis to a systematic way. The fifth section will briefly tell us how the
research will be done in terms of analytical models, data collection, and data
analysis. The final section will describe structure of the thesis.
1.1 RESEARCH CONTEXT
Efficient market hypothesis (EMH) has been at the center of debates in financial
literature for several years. The term efficiency is used to describe a market in
which all relevant information is impounded into the price of financial assets. If
the capital market is sufficiently efficient, investors cannot expect to achieve
superior profits from their investment strategies. As a result, Capital Asset
Pricing models can be useful for various investment decisions. In the economic

perspective, the efficient market is even more important because it implies that
the stock market is well functioning in scarce resource allocation. However, this
is not always the case, especially in the emerging stock markets.
The last decades have witnessed spectacular growth in both size and relative
importance of the stock markets in developing countries. High economic growth,
the pursuit of liberalization policies, and trends towards financial market
globalization provided the environment in which stock markets could thrive. In
addition, foreign equity managers were attracted to these markets by the
potentially high rates of return offered and the desire to pursue international
diversification. According to Antoniou and Ergul (1997), as these capital markets
have developed, considerable attention has been given to the question of whether
they function efficiently. But why the efficiently functioning stock market
becomes so important that every developing country does its best to direct
toward.
Islam and Khaled (2005) calls developing countries as „capital starved
economies‟, so efficient allocation of scarce resources and encouragement of
private foreign investment are both of vital importance. They also stated that the



2
success of an increasing privatization of these economies will depend crucially
on the presence of an active and efficient stock market. Indeed, rational investors
expectedly drive their investments into the most profitable projects, given
acceptable risks. The efficient market can address the „mixed feelings‟ problem,
which investors are always skeptical about the intrinsic value of any stock under
consideration. This may lead their decisions based on others. In other words, this
phenomenon is commonly considered as herding behavior. For foreign investors,
inefficient markets are usually equivalent to high risky markets when making
their investments abroad. Hence, they tend to apply higher hurdle rates, which in

turn underestimate investment opportunities in developing countries. Eventually,
it‟s hard for any developing country with inefficient/weak stock market to attract
foreign portfolio investment flows. In recent years, the intensity of foreign direct
investment competition among developing countries becomes fiercer, so foreign
indirect investment may become a feasible alternative for economic development.
For above reasons, the questions of whether the markets price securities
efficiently and what makes markets informationally efficient or inefficient turn
out to be ultimately empirical issues. An understanding of these issues will help
to determine the appropriate regulatory framework for the establishment of the
efficiently functioning stock market. This appears to be the case of Vietnam.
1.2 THE PROBLEM STATEMENT
Since its foundation in July 2000, the Vietnamese stock market has dramatically
expanded and become one of the most important sources of capital mobilization.
Up to June 2009, the Vietnamese stock market has 352 listed companies and a
market capitalization of about US$17.5 Billion, approximately 21.3 percent of
Vietnam GDP, which even reached above 45 percent before the financial crisis
(Thomson Reuters).
Despite its impressive growth, the Vietnamese stock market is really
struggling with various typical weaknesses of an emerging market (Truong,
2006). First, it is not fully characterized by the depth and maturity of a stock
exchange observed in a developed country. The legal framework is weak and few
alternatives are available for investors. Interest rates are strictly controlled by the
State Bank. The government deeply intervenes into stock trading transactions.
Accordingly, investors tend to speculate, and thus cause high market volatility.
Second, it is widely known that one of the biggest problems facing traders is lack
of transparency. Reporting requirements for listed companies are not well
defined, and significantly less comprehensive than those in the developed stock
markets. Third, publicly information disclosure is not only unclear but also
unreliable. As a result, trading behavior in the Vietnamese stock market may be
much different from that in developed/newly emerging stock markets. Investors

may base their actions on the decisions of others who are well informed about
market developments, by following the market consensus. In other words, the



3
herding behavior may exist in the Vietnamese stock market
1
. Thus, the question
is whether the Vietnamese stock market is informationally inefficient?
Interestingly, the mixed evidence from the study of Truong (2006) in the
2002-2004 period conclude that the Vietnamese stock market is, to some extent,
characterized by the weak-form efficiency in which current prices fully reflect all
information contained in past prices. This implies that, for some stocks, it is not
possible for a trader to make abnormal returns by using only the past history of
prices. However, this lowest form of efficiency cannot assure the Vietnamese
stock market is well functioning in scarce resource allocation and attractive
enough to encourage foreign investors. Both investors and policy makers mostly
concern if the current market prices reflect all publicly available information,
such as information on inflation, economic growth, money supply, exchange
rates, interest rates, dividend payments, annual earnings, stock splits, etc.
Therefore, this thesis tries to investigate whether or not it is possible for market
participants to make consistently superior returns just by analyzing good or bad
news contained in annual reports or other published information. In other words,
the focus of this thesis is to find out the relationship between stock prices and
macroeconomic variables in Vietnam.
1.3 THE RESEARCH OBJECTIVES
This thesis attempts to apply the most widely accepted analytical approach in the
studying of stock markets, namely, the efficient market hypothesis, to investigate
the behavior of the Vietnamese stock prices. Particularly, the goal of this thesis is

to test whether the possibility that the Vietnamese stock market exhibits the semi-
strong form efficiency such that no relationship exists between lagged values of
changes in macroeconomic variables and changes in stock prices over the
December 2000 to June 2009 period. In order to meet this above goal, this thesis
aims to obtain the following specific objectives:
(1) Investigate whether the Vietnamese stock market exhibits the semi-strong
form efficiency;
(2) Examine the speed of adjustment to long-run equilibrium takes place in
the Vietnamese stock market;
(3) Evaluate the possible feedback from the stock prices to the
macroeconomic variables;
(4) Investigate if the financial crisis has any impact on the pattern of
efficiency in the Vietnamese stock market;
(5) Suggest some policy implications for improving the stock market
efficiency.

1
This was already tested by Nguyen (2009).



4
1.4 RESEARCH QUESTIONS AND HYPOTHESES
In order to obtain the above objectives, this thesis will attempt to answer the
following questions:
(1) Do “past” changes in macroeconomic variables explain “current” changes
in stock prices?
(2) Is it correct to say that the Vietnamese stock market takes times to fully
adjust previous shocks in the economy?
(3) Could the stock market movements be used as a leading indicator in

helping formulating current economic stabilization policies in Vietnam?
(4) Does the financial crisis make the inefficiency of the Vietnamese stock
market worse?
Some hypotheses that can be stated regarding the literature review in Chapter 2
and analytical framework in Chapter 3 are:
(1) This thesis hypothesizes that the semi-strong efficiency would not exist in
the Vietnamese stock market. According to Ross et al. (2006), to be semi-
strongly efficient, an investor must be skilled at economics and statistics,
and steeped in the idiosyncrasies of individual industries and companies.
However, to acquire and use such skills requires talent, ability, and time.
And in Vietnam, it is still lack of professional institutions so this is rarely
realistic. In addition, based on previous studies (Ibrahim, 1999; Hanousek
and Filer, 2000; Rousseau and Wachtel, 2000; Wongbangpo and Sharma,
2002; Islam and Khaled, 2005; Atmadja, 2005), most emerging stock
markets, to which extent, remain Granger causality relationships from the
macroeconomic variables to stock prices, and thus they are widely
considered to be informationally inefficient.
(2) This thesis hypothesizes that the Vietnamese stock market could take a
long time to adjust itself toward good or bad news in the economy. This
expectation is expectedly suitable for three reasons. First, the publicly
information disclosure is unclear and unreliable. Second, the ability of
investors in analyzing and understanding macroeconomic and industrial
news is still limited. Third, macroeconomic/market and industrial analyses
are mainly considered by equity analysts of professional investment
companies. Therefore, these concepts are still far away from individual
investors. In addition, based on previous studies (Habibullah and
Baharumshah, 1996; Ibrahim, 1999), the adjustment toward the long-run
relationship in developing markets is extremely slow.
(3) This thesis hypothesizes that the Vietnamese stock market, to which
extent, could play as a leading indicator of the economy as a whole. The

Vietnamese stock prices may provide predictive power for economic



5
variables because we believe that stock prices contain the market
participants‟ expectations of future real activities (Ibrahim, 1999).
(4) This thesis hypothesizes that the financial crisis does really have
significant impact on the Vietnamese stock market. This hypothesis is
based on the evidence from ASEAN countries after 1997 Asian financial
crisis (Atmadja, 2005) and Central Europe countries after the second wave
of voucher privatization (Hanousek and Filer, 2000).
[[1.5 RESEARCH METHODOLOGY
The Granger causality and error correction mechanism tests are employed to test
the proposed hypotheses. Theoretically, these tests are only appropriate when the
variables being analyzed, including stock index and macroeconomic factors, are
stationary and co-integrated. Therefore, it becomes necessary to conduct various
priori tests of integration and cointegration. In so doing, this thesis will apply the
unit root test (specifically the augmented Dickey-Fuller tests and the Phillips-
Perron tests). Following previous studies, this thesis will employ the Akaike
Information Criterion (AIC) and Schwarz Information Criterion (SIC) to
determine the optimal lag lengths.
Data used in Granger causality and error correction mechanism models are
collected from three official sources, namely, Thomson Reuters, Bloomberg and
International Monetary Fund during the December 2000 to June 2009 period.
Similar to most previous studies in emerging markets, this thesis will use the
monthly data because the Vietnamese stock market is not long enough to apply
quarterly data as other developed markets. For this reason, some fundamental
variables presented the whole economy performance such as GDP will be chosen
in a different way. The choice of proxy variables will be discussed in Chapter 3.

For time series variables are usually non-stationary, most previous studies
used the first-order difference form. And this is also the case in this thesis. As
taking differences, the transformed data might take both positive and negative
values, so it sometimes limits the possibility of applying the logarithmic
functional forms in regression analysis.
1.6 STRUCTURE OF THE THESIS
After this chapter the rest of this thesis will be presented four other chapters.
Chapter 2 reviews the literature about the market efficient hypothesis and stock
price determination, including empirical studies. Chapter 3 presents the research
methodology, where details about variables of interest, econometric models,
hypothesis formulating, and data collection. Chapter 4 presents the research
results, indicating whether the Vietnamese stock market exhibits semi-strong
form efficiency. Chapter 5 ends the thesis with a conclusion, policy implications
and limitations for further studies.



6
CHAPTER 2
LITERATURE REVIEW

This chapter will provide a conceptual framework of market efficient hypothesis,
of which we will examine why market efficiency is significant and what are key
determinants of current stock prices. An overview of literature about
informational inefficiency testing helps make clear the research questions and
provide basis for an analytical framework development (research methodology)
discussed in Chapter 3. To achieve these aims, this chapter will be divided into
four sections. The first section will briefly define the concept of efficient market.
To its end, we will understand the essence of market efficiency in stock
valuation, investment, and policy-making process. The second section will

summarize three basic forms of market efficiency so as to help us narrow down
the topic of interest. The third section will justify the determinants of stock
prices, which provide us the underlying foundation for developing the conceptual
model of this thesis. The final section will review a set of previous studies about
market efficiency, especially those in emerging markets in order to logically
drive this thesis into a correct direction.
2.1 THE CONCEPT OF EFFICIENT MARKET
Investors determine stock prices on the basis of the expected cash flows to be
received from a stock and the risk involved. Rational investors should use all the
information they have available or can reasonably obtain. The information set
consists of both known information and beliefs about the future (Jones, 1998).
Regardless of its form, information is the key to the determination of stock prices
and therefore is the central issue of the efficient market concepts.
According to Clarke et al. (2001), the term "efficient market" was first used in
1965 by Fama. In an efficient market, competition forces will cause the full
effects of new information on intrinsic values to be reflected "instantaneously" in
actual prices. The efficient market hypothesis implies that investors are unlikely
to earn abnormal profits by simply predicting the price movements. Indeed, the
underlying engine of price changes only depends on new information. A market
is said to be efficient if prices are quickly adjusted to new information. In this
case, investors will compete to each others in making use of any new information
for profitable opportunities. Interestingly, the higher competition among investors
exists in effort to searching for over- or under-valued securities, the lower
probability of finding and exploiting such mis-priced securities becomes. For the
majority of investors, the gain derived from information analysis may not be in
excess of the transaction costs. Consequently, there is no reason to expect that
market prices are too high or too low. Security prices adjust before an investor
has time to trade on and profit from a new piece of information.

7
Generally, an efficient market is one in which the prices of all securities
quickly and fully reflect all available information about the assets. This concept
postulates that investors will assimilate all relevant information into prices in
making their buy and sell decisions (Jones, 1998). Therefore, the current price of
a stock reflects:
1. All known information, including:
 Past information (e.g., last year‟s or last quarters‟ earnings)
 Current information as well as events that have been announced but are
still forthcoming (such as a stock split)
2. Information that can reasonably be inferred; for example, if many
investors believe that interest rates will decline soon, prices will reflect
this belief before the actual decline occurs.
Jones (1998) also states that an efficient market can exist if the following events
occur:
1. A large number of rational, profit-maximizing investors exist who actively
participate in the market by analyzing, valuing, and trading stocks. These
investors are price takers
2
; that is, one participant alone cannot affect the
price of a security.
2. Information is costless and widely available to market participants at
approximately the same time.
3. Information is generated in a random fashion such that announcements are
basically independent of one another. This is still a question under the
Vietnamese stock market circumstances because information disclosure is
unclear and unreliable.
4. Investors react quickly and fully to the new information, causing stock
prices to adjust accordingly. This is not always a case in the Vietnamese

stock market, because investors are not equally informed.
2.2 FORMS OF MARKET EFFICIENCY
We have defined an efficient market as one in which all information is reflected
in stock prices quickly and fully. The key to assessing market efficiency is
information. According to Jones (1998), in a perfectly efficient market, security
prices always reflect immediately all available information, and investors are not

2
This is similar to the concept of perfect competitive market in microeconomics.



8
able to use available information to earn abnormal returns because it already
impounded in prices. In such a market, every security‟s price is equal to its
intrinsic value, which reflects all information about that security‟s prospects. If
some types of information are not fully reflected in prices or lags exist in the
impoundment of information into prices, the market is less than perfectly
efficient. In fact, the market is not perfectly efficient, and it is certainly not
perfectly inefficient, so it is a question of degree.
In financial theory, the efficient market hypothesis is viewed in three common
forms, depending on the kind of available information embodied (Figure 2.1).
These are commonly classified into weak-form, semi strong-form, and strong-
form efficiency.
Weak Form Efficiency
The weak form is the lowest form of efficiency that defines a market as being
efficient if current prices fully reflect all information contained in past prices
only. That is, nobody can detect mis-priced securities and beat the market by
analyzing the historical prices. This form implies that one should not be able to
profit from using something that “everybody else knows”. For this reason, any

attempt to generating profits by studying the past history of price information
(using technical analysis) is in vain.
Based on the above definition, Fama (1970) suggests three models for testing
stock market efficiency, namely, Fair Game Model, Submartingale Model, and
Random Walk Model. According to Ross et al. (2006), among these models, the
Random Walk is the most powerful model widely used. This model assumes
price changes only depend on new information. Since information itself arrives
randomly, so prices will fluctuate unpredictably.

P
t
= P
t-1
+ Expected return + Random error
t
(2.1)
where
P
t
: Stock price at time t
P
t-1
: Stock price at time t-1
The expected return is a function of a security‟s risk and would be based on the
model of risk and return (Capital Asset Pricing Model, Arbitrage Pricing Model).
And the random component is due to new information on the stock. It is not
predictable from the past prices.

9
Equation (2.1) can be rewritten as follow:
P
t
= Expected return + Random error
t
(2.2)
Equation (2.2) implies that if the weak form of the EMH is true, past price
changes with a k lag period ( P
t-k
) should be unrelated to the future price changes
( P
t
). In other words, a market can be said to be weakly efficient if the current
price reflect all past market data. The correct implication of a weak-form efficient
market is that the past history of price information is of no value in assessing
future changes in price. Thus, most previous studies use autocorrelation test or
unit root test to test whether the stock market exhibits the weak-form efficiency.
And they all conclude that the emerging stock markets are weakly efficient
3
.
 Figure 2.1: Relationship among three different information sets

Source: Ross et al. (2006)
Semi-Strong Form Efficiency
The semi-strong form efficiency suggests that the current price fully incorporates
all publicly available information. Public information includes not only past
prices, but also data reported in a company‟s financial statements (annual reports,
income statements, filings for the State Security Commission, etc.), dividend
payments, stock split announcements, announced merger plans, new product

3
These empirical studies, including those on the Vietnamese stock markets are not explicitly presented in
this thesis, because we mostly concern the next level of market efficiency.


All information



Publicly available
information

Past
Information



10
developments, financing difficulties, the financial situation of company‟s
competitors, expectations regarding macroeconomic factors (such as inflation,
money supply, exchange rate, interest rate, economic growth), etc. Semi-strong

efficiency requires the existence of market analysts who are not only financial
economists able to comprehend implications of vast financial information, but
also macroeconomists, experts adept in understanding processes in product and
input markets. And according to Ross et al. (2006), acquisition of such skills,
however, must take a lot of time and effort. In addition, the “public” information
may be relatively difficult to gather and costly to process. It may not be sufficient
to gain the information from, say, major newspapers and company-produced
publications. One may have to follow wire reports, professional publications and
databases, local papers, research journals, etc., in order to gather all information
necessary to effectively analyze securities.
Fama (1970) stated that, in the stock market, the intrinsic value of a share is
equivalently measured by the future discounted value of cash flows that will
accrue to investors. If the stock market is efficient, the market price of share must
be equal to its intrinsic value. And according to dividend discount model, the
price of the security reflects the present value of its expected future cash flows
which is really affected by the changes in the macroeconomic environment such
as money supply, trade activities, foreign capital flow, interest rate, exchange
rate, industrial production, inflation, etc. From this foundation, Hanousek and
Filer (2000) suggest that a market is considered as semi-strongly efficient if it
simultaneously meets the following conditions. First, a contemporaneous
relationship must exist between real variables and market returns. Second, lagged
values of real variables must not enable a potential investor to predict current
returns in the market. Hence, various empirical studies have employed the
Granger causality approach to test semi-strong form efficiency. We will develop
this idea in the research methodology Chapter.
Strong Form Efficiency
The strong form efficiency states that the current price fully incorporates all
existing information, both public and private (also called inside information). The
main difference between the semi-strong and strong efficiency hypotheses is that,
in the latter, nobody should be able to systematically generate profits even if

trading on information not publicly known at the time. In other words, company‟s
managements (insiders) would not be able to systematically gain from inside
information by buying company‟s stocks ten minutes after they decided (but did
not publicly announce) to pursue what they perceive to be a very profitable
acquisition. The rationale for strong-form market efficiency is that the stock
market anticipates, in an unbiased manner, future developments and therefore the
stock prices may have incorporated all relevant information and evaluated in a
much more objective and informative way than the insiders. According to Ross et
al. (2006), a very strong assumption of this form is that inside information cost is
always zero. However, this assumption hardly exists in reality, so the strong form



11
efficiency is not very likely to hold. This form of market efficiency is, therefore,
beyond the scope of this thesis.
Ross et al. (2006) summaries that semi-strong form efficiency implies weak
form efficiency, and strong form efficiency implies semi-strong form efficiency.
Therefore, it‟s impossible to expect semi-strong efficiency, if the market is
currently weakly inefficient. The efficient market hypothesis has various practical
meanings. However, within this thesis, two fundamental implications are of
special concern.
First, if the weak form efficiency exists, technical trading systems (technical
analysis) that rely on knowledge and use of past trading data cannot be of value.
According to Keilly and Brown (1997), a basic premise of technical analysis is
that stock prices move in trends that persist. Technicians believe that when new
information comes to the market, it is not immediately available to everyone but
typically is gradually disseminated from the informed professional to the
aggressive investing public and then to the great bulk of investors. Also,
technicians contend that investors do not analyze information and not act

immediately. This process usually takes time. Accordingly, they hypothesize that
stock prices move to a new equilibrium after the release of new information in a
gradual manner, which causes trends in stock price movements that persist for
certain periods. This indicates that if the stock market is „weakly‟ efficient and
prices fully reflect all „past‟ relevant information, technical analysis becomes
meaningless.
Second, if the semi-strong form efficiency is true, no form of “standard”
security analysis
4
based on publicly available information will be useful. In this
situation, since stock prices reflect all relevant publicly available information,
gaining access to information others already have is of no value. Traditionally,
fundamental analysts believe that, at any time, there is a basic intrinsic value for
the aggregate stock market, various industries, or individual stocks and that these
values depend on underlying economic factors. As a result, a fundamental analyst
would determine the intrinsic value of an investment asset (common stock, bond)
at a point in time by examining the variables that determine value such as current
and future earnings, interest rates, and risk variables. According to Keilly and
Brown (1997), if the prevailing market price differs from the intrinsic value by
enough to cover transaction costs, an investor should immediately take
appropriate action. However, if all investors can access the same publicly
information, the market price tends to reflect the correctly intrinsic value of an
investment asset. This second implication of EMH raises an important question

4
This implies the conventional fundamental analysis, which seeks to estimate the intrinsic value of a
security and provide buy or sell decisions depending on whether the current market price is less than or
greater than the intrinsic value (Jones, 1998).

12
about the underlying relationships between general economic environment and
stock prices, which is shortly explained in the next section.
2.3 MARKET EFFICIENCY AND VALUATION
According to Damodaran (2002), the question of whether markets are efficient,
and, if not, where the inefficiencies lie, is central to investment valuation. If
markets are in fact efficient, the market price provides the best estimate of value,
and the process of valuation becomes one of justifying the market price. If
markets are not efficient, the market price may deviate from the true value, and
the process of valuation is directed toward obtaining a reasonable estimate of this
value. Those who do valuation well, then, will be able to make higher returns
than other investors because of their capacity to spot under- and over-valued
firms. To make these higher returns, though, markets have to correct their
mistakes over time. There is also much that can be learned from studies of market
efficiency, which highlight segments where the market seems to be inefficient.
These inefficiencies can provide the basis for screening the universe of stocks to
come up with a subsample that is more likely to contain undervalued stocks.
Given the size of the universe of stocks, this not only saves time for the analyst,
but it increases the odds significantly of finding under- and overvalued stocks.
Damodaran (2002) also said that an efficient market is one where the market
price is an unbiased estimate of the true value of the investment. The true value is
also known as the intrinsic value, which becomes the central of concern in
fundamental analysis. Markets do not become efficient automatically. It is the
actions of investors, sensing bargains and putting into effect schemes to beat the
market, that make markets efficient. For this fact, Damodaran (2002) pointed out
three propositions about market efficiency.
First, the probability of finding inefficiencies in an asset market decreases as
the ease of trading on the asset increases. To the extent that investors have
difficulty trading on an asset, either because open markets do not exist or there

are significant barriers to trading, inefficiencies in pricing of the asset can
continue for long periods.
Second, the probability of finding inefficiency in an asset market increase as
the transactions and information cost of exploiting the inefficiency increases. The
cost of collecting information and trading varies widely across markets and even
across investments in the same markets. As these costs increase, it pays less and
less to try to exploit these inefficiencies.
Third, the speed with which inefficiency is resolved will be directly related to
how easily the scheme to exploit the inefficiency can be replicated by other
investors. The ease with which a scheme can be replicated is related to the time,
resources, and information needed to execute it. Since every few investors single-
handedly possess the resources to eliminate inefficiency through trading, it is



13
much more likely that inefficiency will disappear quickly if the scheme used to
exploit the inefficiency is transparent and can be copied by other investors.
Above analysis provides three important points. First, some segments of the
Vietnamese stock market can be weakly efficient. Second, the Vietnamese stock
market as a whole can be semi-strongly inefficient because it seems to be costly
to obtain appropriate public information, especially macroeconomic variables.
Third, fundamental analysis can provide a good conceptual framework for
identifying key determinants of stock prices. As we will discuss in the
consecutive section of valuation models that the intrinsic value of any asset is the
present value of expected future cash flows on it which in turn determined by
expected growth and discount rate. These fundamentals are only determined by
expected macroeconomic conditions. In an efficient market, the current market
prices (P
t

) randomly deviate around its true value (V
t
), so it must also depend on
the expected macroeconomic conditions. During this thesis, the term “expected”
implies the period t+1. In other words, in an efficient market, all past
macroeconomic conditions (i.e. t-1 or t-p) do not explain the intrinsic value, and
thus the current market prices as well. Therefore, if we find any relationship
between past macroeconomic conditions and current stock prices, we can
conclude that the market is semi-strongly inefficient.
2.4 THE DETERMINANTS OF STOCK PRICES
2.4.1 The Determinants of True Value
According to Damodaran (2002), there are three fundamental approaches to
estimating the true value of investments
5
, namely, discounted cash flow valuation
(DCF), relative valuation, and contingent claim valuation. However, the DCF is
the foundation on which all other valuation approaches are built. To do relative
valuation correctly, we need to understand the fundamentals of DCF valuation.
To apply option pricing models to value assets, we often have to begin with a
DCF valuation. Although there are various variants of DCF models
6
, we will only
discuss the easiest one, called Dividend Discount Model (DDM), because our
objective is to identify key determinants of the true value, rather than
fundamental analysis.

5
During this thesis, we just call the term “investment” as the common stock investment.
6
See Damodaran, 2002, Investment Valuation: Tools and Techniques for Determining the Value of Any

Asset, 2
nd
Edition, Wiley & Sons.



14
The dividend discount model (DDM) assumes that the true value of a
common stock is the present value of all future dividends
7
. This model is
specified as follows:
)k1(
D

)k1(
D
)k1(
D
)k1(
D
V
e
3
e
3
2
e
2
e

1
j


n
1t
t
e
t
)k1(
D
(2.3)
where
V
j
= value of common stock j
D
t
= dividend during period t
k
e
= cost of equity
For infinite period model, with assumption that the future dividend stream will
grow at a constant rate, g%/year, the equation (2.3) is then rewritten as follows:
n
e
n
0
2
e

2
0
e
0
j
)k1(
)g1(D

)k1(
)g1(D
)k1(
)g1(D
V


gk
D
e
1
(2.4)
where
D
0
= dividend in period 0 (current period)
D
1
= dividend in period 1
k
e
= cost of equity

g = constant growth rate

7
This model was initially set forth in J.B.Williams (1938), and was subsequently reintroduced and
expanded by Myron J. Gordon (1962).



15
 Figure 2.2: Breakdown of Risk




Source: Damodaran (2002)
The equation (2.4) tells that the intrinsic value of a stock is determined by two
fundamentals, including cost of equity and expected growth rate. According to
Keilly and Brown (1997), two variables k
e
and g are independent to each other
because k
e
depends heavily on risk, whereas g is a function of the retention rate
(or reinvestment rate) and the expected return on equity investments (ROE).
Risk is commonly classified into two components. The first component
usually relates to one or a few firms. In financial economics, this category is
known as firm-specific or unsystematic risk. Another risk component has broader
effects on every stock such as interest rate and inflation. This category is known
as market or systematic risk. The breakdown of risk is illustrated in Figure 2.2.
Figure 2.2 shows us that thanks to diversification strategies, rational investors

eventually face market risk, which in turn depends on the macroeconomic and
political conditions (Damodaran, 2002). Given this justification, we can
demonstrate determinants of k
e
as follows:
k
e
= f(R, I, E, FX, P) (2.5)
Projects may do
better or worse
than expected
Competition may be
stronger or weaker
than anticipated
Entire industry
may be affected
by action
Exchange rates and
Political risk affect
many stocks
Interest rates,
inflation, and
news
Firm-specific
Marketwide
Actions/Risk
that affect
only one firm
Actions/Risk
that affect all

investments
Affects few firms
Affects many firms



16
where
R = Interest Rate
I = Inflation
E = News about Economy
FX = Exchange Rate
P = Political Stability
Turning back the second variable of the intrinsic value, g, we realize that the
growth rate in net income (for DDM models only) is a function of two
fundamental variables, including retention ratio (b) and return on equity
investment (ROE).
g = b * ROE (2.7)
Because retention ratio depends mainly on specific firm‟s dividend policy, so the
rest of our concern is about the return on equity investment. In financial
economics, we have the famous equation as follows:
ROE = ROC + D/E[ROC – r(1-t)] (2.8)
where
ROC = Return on capital investment
D/E = Capital structure
r = Interest expense on debt/book value of debt
t = Tax rate on ordinary income
Although the return on equity is affected by the leverage decisions of the firm,
it‟s also affected by macroeconomic factors. Therefore, g will eventually depend
on both monetary and fiscal policies. From equation (2.4) to equation (2.8), given

political stability, we can conclude that the intrinsic value of a certain stock is a
function of the following factors:
V
j
= f( R, I, Es, FX, TB, GB, M) (2.9)
Where denotes changes in macroeconomic variables, R is interest rate, I is
inflation, Es are economy health variables, FX is foreign exchange, TB is trade
balance, GB is government budget, and M is money supply.
If we assume the market is efficient, the stock price randomly deviates around
its true value, the stock price is then demonstrated as follows:



17
P
j
= V
j
+ (2.10)
Thus, the stock price can be written as the following function:
P
j
= f( R, I, Es, FX, TB, GB, M, ) (2.11)
For these reasons, general economic environment influences stock prices. It is
obvious that monetary and fiscal policy measures enacted by various agencies of
national government influence the aggregate economy. The resulting economic
conditions influence all industries and companies within the economy. Fiscal
policy initiatives such as tax cut credits or tax cuts can encourage spending,
whereas additional taxes on income or goods can discourage spending. Increases
or decreases in government spending also influence the general economy. All

such policies influence the business environment for firms that rely directly on
those expenditures. In addition, we know that government spending has a strong
multiplier effect. Monetary policy produces similar economic changes. A
tightening monetary policy that reduces the growth rate of the money supply
reduces the supply of funds for working capital and expansion for all businesses.
Alternatively, a restrictive monetary policy that targets interest rates would raise
market interest rates and therefore firms‟ costs, and make it more expensive for
individuals and firms. Monetary policy also affects all segments of an economy
and that economy‟s relationship with other economies.
Keilly and Brown (1997) states that any economic analysis requires the
consideration of inflation, which causes differences between real and nominal
interest rates and changes the spending and savings behavior of consumers and
corporations. In addition, unexpected changes in the rate of inflation make it
difficult for firms to plan, which inhibits growth and innovation. Beyond the
impact on the domestic economy, differential inflation and interest rates
influence the trade balance between countries and the exchange rate for
currencies. In addition to monetary and fiscal policy actions, events such as war,
political upheavals in foreign countries, or international monetary devaluations
produce changes in business environment that add the uncertainty of sales and
earnings expectations and therefore risk premium required by investors.
2.4.2 The Determinants of Stock Price
Jones (1998) says that although the dividend discount models, using expected
dividends and cost of equity, can help identify the ultimate determinants of stock
prices, a more complete model of economic variables is desirable. This model
was first introduced by Keran in 1971. Jones (1998) emphasizes that although
presented many years ago, this classic model remains an accurate description of
the conceptual nature of stock price determination then, now, and for the future.
The two primary exogenous policy variables, G and M, affect stock prices
through two channels. First, they affect total spending (Y), which, together with