ECONOMETRICS

Econometrics

Econometrics

Introduction

Events surrounding the financial crises of the 1990s established the analysis of the behaviour and investment practices of emerging market investors firmly on the academic research agenda. A central theme contained in a series of recent studies, comprehensively summarised in Frankel and Schmukler, 1996 and Frankel and Schmukler, 1998, is that differing investor sentiment and/or the existence of asymmetric information in financial markets may induce divergent expectations across the foreign and local investment communities. Ultimately, this will be reflected in different trading behaviour.

Commentators argue that the impact of such investor heterogeneity may be particularly evident during times of market turbulence, such as that experienced during a financial crisis. One hypothesis, expressed at various times by the International Monetary Fund (IMF), is that local investors tend to be the initiators of any crisis. This possibility reflects these investors' proximity to relevant economic and policy related information, enabling them to be the first to react to any deterioration in local economic conditions. Other commentators, including Dornbusch and Park (1995), Radelet and Sachs (1998) and Stiglitz (1998), acknowledge the destabilising potential of foreign investors. Indeed, the Prime Minister of Malaysia, in well-documented remarks, places the responsibility for the 1997 Asian crisis firmly at the feet of the international investor community, in particular foreign speculative investors.

In this paper, we provide empirical evidence on crisis-related investor behaviour by analysing the trading patterns of both local and foreign investors on an important emerging market severely affected by the Asian crisis, namely Indonesia. We focus on two issues. The first question is whether there is any evidence of herding by foreign and/or local investors. Simply stated, herding refers to any inherent tendency for classes of investors to trade as a group., 5 We formally document herding by computing the standard herding measure adopted in the literature, developed by Lakonishok et al. (1992), and applied by Wermers (1999) and Choe et al. (1999). The second issue, the interpretation of which is somewhat conditioned on the outcome of the first, is whether foreign or local trading behaviour could be said to have destabilized the Jakarta Stock Exchange (JSX) equity market. Following Nofsinger and Sias (1999), destabilizing trading behaviour in this paper is identified with positive feedback trading by particular classes of investors (buying (selling) following asset return increases (decreases)). In the present context, this implies the existence of positive correlation between herding-type behaviour and past returns.

The study contributes to the literature in several respects. First, the majority of existing studies of collective trading patterns are undertaken for developed capital markets, in particular the US (Chang et al., 2000; Wermers, 1999 and Lakonishok et al., 1992) and Japan (Kim and Nofsinger, 2000 and Chang et al., 2000). The only studies of emerging markets of which we are aware are those undertaken for Korea by Choe et al., 1999 and Choe et al., 2000, Kim and Wei (2002), and Chang et al. (2000), and for Taiwan by Chang et al. (2000). This study, to our knowledge the first undertaken ...