This study tests the semi-strong form of market efficiency by investigating the reaction of stock prices to dividend announcements. It analyzes cash, stock, and simultaneous cash and stock dividend announcements of 79 companies listed on the Karachi Stock Exchange from July 2004 to June 2007. Abnormal returns from the market model are evaluated for statistical significance using the t-test and Wilcoxon Signed Rank Test. The findings suggest negligible abnormal returns for cash dividend announcements. However, the average abnormal and cumulative average abnormal returns for stock and simultaneous cash and stock dividend announcements are mostly positive and statistically significant.
Keywords: Stock prices, market efficiency, dividend announcements, Pakistan.
JEL Classification: G14.
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The Efficient Market Hypothesis proposed by Fama (1965) suggests three types of market efficiency: (i) weak, (ii) semi-strong, and (iii) strong. The weak form of market efficiency proposes that current stock prices reflect all past information. It also suggests that changes in stock prices are random and no investment strategy that is based on past information can yield above average returns to the investor. This implies that technical analysis will not be rewarded with above average returns. The semi-strong form of market efficiency (informational efficiency) proposes that current stock prices incorporate material public information and changes in stock prices will only lead to unexpected public information. This suggests that fundamental analysis will not be rewarded with above average returns. Finally, the strong form of market efficiency proposes that insider trading will not be rewarded as current stock prices incorporate all material nonpublic information (Reilly and Brown, 2008).
Market efficiency, however, does not simply occur by itself or because information is freely and timely available in the market. As Osei (1998) suggests, it depends heavily on the analytical and interpretational abilities of those who trade in the market and the time they have and are ready to devote to obtaining and spreading price-sensitive information.
The semi-strong form of market efficiency has mostly been investigated using event study methodology. Information disclosures related to dividends and earnings announcements, macroeconomic variables, stock repurchase announcements, and mergers and acquisitions, etc., have been investigated in different studies to test the semi-strong form market efficiency.
1.1. Stock Prices, Dividends, and Semi-Strong Market Efficiency
Although there is abundant theoretical and empirical research on the relevance of and relationship between stock prices and dividends, it is inconclusive. Graham and Dodd (1951) point toward the relevance of and hence investors' preference for dividends. Contrary to this, Miller and Modigliani (1961) propose that, in a world of no taxes and transaction costs, dividends are irrelevant to investors. However, empirical research has revealed findings that support the relevance of the dividends proposition.
In his seminal investigation of dividends policy, Lintner (1956) suggests that a firm's management will resort to increasing dividends if it believes that the increase will be permanent. Bhattacharaya (1979) explains that there exists asymmetric information between a firm's management and its shareholders: hence, an increase or decrease in dividends conveys price-sensitive information to shareholders and prospective investors. Miller and Rock (1985) and John and Williams (1985) also support the signaling or information content proposition. Brickley (1983), Healy and Palepu (1988), and Aharony and Dotan (1994) find support for the information content of dividend hypothesis, while Penman (1983) and Benartzi et al (1997) fail to do so.
Black (1976) and Easterbrook (1984) propose that dividends play a role in decreasing or increasing agency conflict between management and shareholders. …