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Reorganizations to stock indices and their associated effects have drawn considerable attention of investors, index fund managers and also arbitrageurs. Generally, the previous literature on stock index reorganizations reports that stocks added to (deleted from) a particular index experience distinct effects such as changes in price and volume, bid-ask spread, and the firm’s cost of capital. Another dimension that has drawn the attention of researchers is the effect of stock index reorganizations on the firm performance.
There are several hypotheses tested by the researchers in association with the stock index reorganizations. The Downward Sloping Demand Curve (DSDC) hypothesis examined by Shliefer (1986), Lynch and Mendenhall (1997) and Mazouz and Saadouni (2007) assumes a permanent increase (decrease) in price and volume following an index revision. The Price Pressure Hypothesis (PPH) observed by Harris and Gurel (1986), Biktimirov et al. (2004), and Rahman and Rajib (2014) posits a reversal of the increase (decrease) in price and volume in a short-span of time following index reorganization. The Liquidity Cost Hypothesis (LCH) studied by Dhillon and Johnson (1991), Beneish and Whaley (1996), and Hegde and McDermott (2003) proposes an association between index changes and stock liquidity. This hypothesis assumes that index additions experience increase in liquidity due to decrease in transaction costs, while the reverse is true with the exclusions. An increase (decrease) in liquidity of a stock may lead to a decrease (increase) in the cost of equity capital.
In addition to the various contending hypotheses discussed above, the Information Content Hypothesis (ICH) presumes a permanent change in price and volume, since stock index inclusion or exclusion conveys some information to the market. Jain (1987) reported that the announcement of an addition or deletion from the S&P 500 index conveys information to the investing public, and hence causes changes in prices of stocks. Beneish and Whaley (1996) documented that the stocks added to the S&P 500 index experience increase in prices and higher liquidity due to changes in the information environment. Denis et al. (2003) studied additions to S&P 500 and their earnings expectations, and reported that inclusion to an index leads to enhanced corporate performance. They presumed that index additions result in greater monitoring of management by the investors, and the cost of managerial reputation on the part of the manager is greater for a firm belonging to an index compared to another firm that is not part of any index. Further, they assumed that the index inclusion announcement conveys a positive message to the investors about the future performance. Hrazdil and Scott (2009) studied the impact of index addition announcements on firm’s future economic performance. They extended the work of Denis et al. (2003) by examining the observed unexpected earnings around the date of announcement. They rejected the findings of Denis et al. (2003) by reporting no evidence of increased earnings following inclusion.
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