This study suggests an investment sentiment index that exploits daily information on individual firm characteristics and individual investors’ trading behavior in the Korean stock market. We empirically examine the explanatory power of our sentiment indicator for the cross-sectional returns of individual stocks and portfolios after controlling for appropriate market risk factors. While previous studies use a single variable or multiple market-wide variables to measure investor sentiment, we efficiently measure sentiment by extracting common factors from various individual firm characteristic variables and trades by domestic individual investors, who are normally regarded as noisy and behaviorally biased. By extending methodologies suggested by Ryu, Kim, and Yang (2017), Yang, Ryu, and Ryu (2017), and Yang and Zhou (2015, 2016), we construct a composite sentiment indicator based on principal component analysis using five key variables: the relative strength index, psychological line index, adjusted turnover rate, logarithm of trading volume, and individual investor buy-sell imbalance. We analyze how the sentiment effect varies depending on firm and stock characteristics by constructing several portfolio groups classified according to firm size, stock price, book-to-market ratio, excess return, volatility of past returns, individual trading ratio, and foreign investors’ holding for individual companies. We categorize the portfolios into five quintile groups based on each criterion and generate an investor sentiment index for each portfolio group. Our sample data comprise a daily stock trading dataset for all available manufacturing companies listed on the KOSPI stock market from 2000 to 2015. This sample mitigates possible industry effects and biases and enables us to investigate the uncontaminated results for sentiment effects by maintaining homogeneity among the sample firms. To ensure consistency and clarity, we exclude companies facing trading suspension and/or administrative issues. We extend the literature on investor sentiment and contribute to research by constructing a composite sentiment indicator that includes information on various stock and firm characteristics. We use buy-sell order imbalance information on individual investors, as their investment strategies and trading patterns are likely to be affected by psychology, sentiment, and mood. Our sentiment indicator exhibits more robust explanatory power than existing sentiment measures do, as it successfully explains the cross-sectional asset returns after controlling for the four risk factors. Our empirical analyses using this sentiment indicator provide several important findings and implications. We find that our investor sentiment indicator may explain cross-sectional stock and portfolio returns, even after controlling for Fama and French factors (market factor, size factor, and book-to-market factor) and the additional momentum factor suggested by Carhart (1997). It is particularly interesting that the sentiment indicator maintains its explanatory powers after considering and controlling for the momentum effect, consisting of representative time-series stock price patterns driven by investor psychology and behavioral biases. This result indicates that the sentiment indicator may be an important factor in explaining asset price movements. The analyses considering firm and stock characteristics show that the sentiment effect varies significantly according to stock and firm characteristics, being more prominent for smaller firms as well as stocks that are lower priced, have higher book-to-market ratios, have greater excess returns, and are more volatile. The sentiment effect also increases for stocks exhibiting greater individual investor participations, while its effect is lower when stocks are mostly owned by foreign investors, who are mostly professional institutional investors. These results tend to suggest that domestic individual investors are uninformed and noisy traders, while foreign institutional investors are better informed and more sophisticated. Considering that our sentiment indicator captures firm and stock characteristics reflecting individual stock trading on a daily basis, our methodology can be easily applied to analyze sentiment issues in various industry sectors at a relatively high-frequency level. The sentiment indicator can also be used to examine the transmission and spillover effect of market sentiment and behavior across financial markets and countries.

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We analyze cause and effect of Korean institutional investors’ selling behavior of IPO shares right after initial trading. Most of IPO shares sold by institutions right after initial trading are assumed to be originally allocated to them in bookbuilding process. Thus, institutions’ selling behavior of IPO shares right after initial trading is interpreted as IPO flipping that is reported by Boehmer, Boehmer, and Fishe (2006). Following the methodology of Boehmer et al. (2006), we separately analyze the initial flipping on first three trading days after IPOs, and the second flipping thereafter to the twenty fifth trading days. Samples of our study cover firms that undertook IPOs in year 2003 through year 2014 in Korea. Firms’ financial data, stock prices, trading volumes, and market indexes are obtained from FnData Guide. IPO-specific data, such as bookbuilding results, allocation ratios, etc. are obtained from investment prospectus reported in DART (disclosure system of Financial Supervisory Services). Our samples covers 674 firms: 110 firms of Securities Market IPOs, and 564 firms of KOSDAQ IPOs. We have found that IPO initial returns are significantly negatively related to the first flipping, but significantly positively related to the second flipping. This result implies that Korean institutional investors that are allocated with IPO shares take profit in the second flipping. We have also found that the main players of short-term sales of IPOs are institutional investors. The voluntary lock-up of institutional investors does not play a meaningful role in constraining their selling behavior of IPO shares. Right after the voluntary lock-up period, institutional investors are selling IPO shares. The initialflippingon the first three days after IPOs are not related to the amount of institution allotments. We have also analyzed the effect of venture capital investment on the IPO stock return of the first trading day. Empirical results show that IPO firms with venture capital investments have significantly lower stock return on the first day of trading than those with no venture capital investment. This result would be interpreted as the certification effect of venture capitals. Institutional investors tend to sell more IPO shares both in the first and second flipping when firms have venture capital investments. In the analysis of long-term return behavior, we have found that the first flipping of institutional investors does not affect long-term market-adjusted returns of IPO shares. However, the second flipping activities of institutional investors significantly decrease long-term returns measured by market adjusted returns over 3, 6, and 9 month period after IPOs. This result implies that institutional investors allocated with IPO shares tend to flip shares right after IPOs regardless of long-term prospect of IPO firms. In contrast, the second flipping is mainly driven by venture capitals that have invested in IPO firms before these firms go public. Noting that the second flipping is negatively related to long-term return performance, venture capitals that have long relationship with firms have the ability to predict future operational prospect of IPO firms. The more shares are allocated to institutional investors, the worse are market-adjusted returns over the period of 6, 9, and 12 months after IPOs. This result is related to the dynamic information acquisition model of Benvenist and Spindt (1989). In a situation where IPO allotment ratio among investor groups are mostly fixed as in Korea, significant underpricing would be an effective way of compensation for institutional investors in the dynamic information acquisition model of Benvenist and Spindt (1989). Thus, when more IPO shares are allocated to institutional investors, those shares are more likely to suffer from underpricing.

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This paper examines how fund flows predict subsequent market returns, especially focusing on the validity of using fund flows as a measure of investor sentiment for the Korean financial market. For this purpose, we use a variety of fund flow indicators. In contrast to the previous literature in Korea, which has solely analyzed the fund new sales and redemptions, this article develops a fund transfer index, i.e., the shifts between equity funds and bond funds, and also uses it as a proxy variable for investigating the relationships between fund flows and market returns. Another contribution of the paper is that, based on the newly developed indicator, we investigate whether the fund transfer index has a significant impact on market returns. Therefore, this study can be expected to fill the gap in the literature which has mainly dealt with the relationships between equity fund flows and stock returns and between bond fund flows and bond returns. Against this backdrop, the paper attempts to address three research questions in order. First, we examine whether various fund flow indices such as fund-new-sales and redemptions-indices and fund-transfer-indices for equity and bond funds in Korean markets could be viewed as a relevant measure for investor sentiment. It is rather well documented in the literature that investor sentiment affects market returns. Here, a more important question is how to measure investor sentiment and quantify its effects. Generally speaking, investor sentiment is the overall attitude of investors toward future cash flows or fundamentals and the feeling or tone of investors as revealed through the activity and price movement of the securities traded in markets. Thus, the better sentiment measure should quantify the biases of market prices which are not explained by economic fundamentals. More specifically, positive sentiment pushes asset prices to extraordinarily higher levels in the short run but leads them to equilibrium in the long run. The underlying key assumption here is that individual investors are often noise traders potentially because they are less informed and less capable in information processing than institutional investors. Having said that, this paper verifies those fund flow indices could satisfy the prerequisites for a relevant measure of investor sentiment in the Korean financial markets. Second, by conducting the lead-lag analyses, we examine the relationships between fund flows and financial asset prices. That is, the paper checks whether contemporaneous flow indices and the accumulated flow indices affect market returns. In this process, we verify whether fund flows could measure investor sentiment and whether they could predict market returns originated from mispricing. Third, this article analyzes whether fund transfer flows have a significant effect on excess returns in equity returns and bond returns, respectively. This is in contrast to the previous studies which have focused only on the relationships between equity fund flows and excess returns in stock markets. Our main findings can be summarized as follows. First, we find that fund flows in Korea fail to satisfy the prerequisite conditions for investor sentiment, which is ‘short-run upsurge and long-run reversal’ pattern. This finding highlights the limitations of previous domestic studies that measure investor sentiment with fund flows. Based on this result, we argue that the previous studies, which use fund flows as a proxy for investor sentiment, have a consequential problem in common due to immature fund markets. This conjecture still seems to be consistent with the extant literature which points out the instability of fund flows and structural changes around the fund markets of Korea. Second, we find that fund flows have a substantial prediction power on market returns. For instance, while the equity fund net inflow index (denoted to NEAR) can predict stock market excess returns over three to six month horizons, the bond fund net inflow index (denoted to NBAR) and the fund transfer index (denoted to FAR) can predict bond market returns over one to six months ahead. Moreover, our finding confirms that the inclusion of the fund transfer index along with other economic variables could significantly increase the prediction power, measured in Adjusted R-squared, on market returns. Last but more importantly, we firstly document that fund transfer flows between equity funds and bond funds could be an useful indicator to explain excess returns in the Korean stock and bond markets. Together with the second finding, this result implies that the fund transfer between equity and bond funds has information regarding the asset allocation of investors, reflecting the prospect on future market conditions. On the contrary, the fund flows not including the fund transfer information contain only on the long-term savings and withdrawals.

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I demonstrate that the rank momentum strategy advanced by Chen, Chou, Ko, and Rhee (2016, Nonparametric momentum strategies, working paper, henceforth CCKR) is profitable in Korea. The strategy constructed on the basis of average past ranks of daily returns generates significant momentum profits for up to four years following portfolio formation. Further, I find evidence that the profitability is attributed to investor underreaction to non-salient information embedded in stock prices. Rank measures capture the non-salient component in stock prices largely neglected by investors, and therefore, the rank can predict the future changes in stock prices. The main findings of this study are as follows. First, rank momentum strategies generate significant returns for holding periods ranging from six months to four years subsequent to portfolio formation. In particular, the risk-adjusted return of the rank momentum strategy constructed by buying stocks with high average ranks and short selling those with low average ranks is 0.81% per month (t-statistics 2.90) when the long-short portfolio is held over six months. The profitability of rank momentum strategies is robust to controls of various cross-sectional effects such as size, book-to-market, illiquidity, and idiosyncratic volatility. Second, rank-based momentum strategies even work better than the price momentum strategies proposed by Jagadeesh and Titman (1993, Returns to buying winners and selling losers: implications for stock market efficiency, J. Finance 48, 65-91, henceforth JT). For example, over one year holding period following formation, the rank momentum earns an average monthly profit of 0.44%, while the profits of JT price momentum are even negative. The rank momentum strategies also outperform the 52-week high momentum strategies suggested by George and Hwang (2004, The 52-week high and momentum investing, J. Finance 59, 2145-2176). Third, rank momentum profits tend to fall for longer holding periods but are not reverted to become negative afterward in contrast with that of JT price momentum. The literature documents that investor overreaction leads to long-term reversals but investor underreaction does not. In this regard, the lack of reversals indicates that the rank momentum profits are not driven by the overreaction, but by the underreaction. Fourth, rank momentum profits primarily come from loser stocks’ underperformance. Fama-MacBeth (1973, Risk, return, and equilibrium: Empirical tests, J. Polit. Econ. 81, 607-636) regressions results reveal the short-leg of the long-short strategy yields persistent negative returns over holding periods ranging from six months to two years, while the profit of long-leg is positive only for the first six months. Consistent with the earlier findings in my study, this result also indicates that the rank momentum is associated with stock mispricing, which has not been eliminated by arbitragers. In particular, the rank momentum is closely related to stock overpricing and the resulting reduction. Arbitragers face greater impediments when they short-sell an overpriced stock than when they purchase an underpriced stock. The difficulty of short-selling deters arbitrage that reduces the overpricing. Accordingly, the underreaction of loser stocks to bad news is more persistent than underreaction of winner stocks to good news, which leads to persistent rank momentum profits for loser stocks. Lastly, the profitability of the rank momentum is strong among stocks with weak salient features, where the salience is proxied by the presence of extreme price changes. This evidence indicates that the rank momentum is the investors’ underreaction, rather than overreaction, is an underlying cause of the rank momentum. The literature including Bordalo, Gennaioli, and Shleifer (2013, Salience and asset prices, American Economic Review 103, 623-28) and CCKR asserts that investors tend to overreact to salient information and underreact to non-salient information. Weaker rank momentum in stocks with higher salient features lends support to the conjecture that the rank momentum profits are attributed to investor underreactions, not due to investor overreactions. Overall, our empirical findings for the Korean stock market is quite consistent with that for the U.S. stock market. As in CCKR, we provide ample evidence that rank captures the non-salient information embedded in stock prices, which is largely due to investors’ underreaction, and the profitability of rank momentum strategy primarily comes from the underreaction to bad news among loser stocks. This study contributes the literature on the momentum phenomenon in the Korean stock market. I explore the sources of the profitability of rank momentum strategies by comparing it with that of the traditional JT momentum strategies. Moreover, this study sheds light on the understanding of investors’ reactions to non-salient information in the Korean stock market. Investors tend to underreact to non-salient news, and the overpricing, which is due to the underreaction, and the resulting reduction produces momentum in stock prices.

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This study examines the effect of financial constraints on stock returns in the Korean stock market from April 2002 to March 2016. Several studies have examined the relation between financial constraints and stock returns. The main issue in these studies is whether financial constraints are an undiversifiable risk and, if so, whether this risk is priced. However, the results have been inconsistent, and there is no consensus on this issue in the literature. Moreover, only a few studies have examined this issue specifically with respect to the Korean stock market. In this study, we thoroughly examine the relation between financial constraints and stock returns in the Korean stock market. Financial constraints arise due to frictions in the process of raising funds from capital markets. If firms have difficulty raising enough funds to invest in profitable projects or are financially constrained, they lose profitable investment opportunities, and then the value of such financially constrained firms declines. Thus, investors perceive financial constraints as risk and demand a premium for such risk. Lamont, Polk, and Saa-Requejo (2001) test whether financial constraints can be a common risk factor that affects stock prices. These authors construct a factor based on the degree of financial constraint by buying long financially constrained firms and selling short financially unconstrained firms. They find a negative relation between financial constraints and stock return. That is, financially constrained firms earn lower stock returns than do financially unconstrained firms. By decomposing the sample period into expansion and contraction periods, Campello and Chen (2010) find that the stock price of financially constrained firms rises more than that of financially unconstrained firms during expansion periods, whereas it falls more than that of financially unconstrained firms during contraction periods. They thus conclude that financial constraints can affect stock prices. To measure financial constraints, previous studies use an index, such as the Kaplan and Zingales (1997) (KZ) index, or individual proxy variables. Those researchers that use the KZ index use the estimated coefficients listed in it to directly compute the index value and in turn use this index value to measure the degree of financial constraint. However, Farre-Mensa and Ljungqvist (2016) argue that this method is problematic. Almeida, Campello, and Weisbach (2004) therefore suggest an approach to determine whether a given measure, such as the KZ index, precisely represents the degree of financial constraint. This approach is to use the sensitivity of cash flows to cash holdings. We use this approach to select the variables to be included in the index that we then use to measure the degree of financial constraint in the Korean stock market. We select the following variables for the index: R&D growth rate, cash and cash equivalents ratio, and sales growth rate. To our knowledge, this index is the first to measure financial constraints in the Korean literature. We construct five portfolios by sorting all Korean firms based on our index values, and we find that average stock returns tend to increase across the portfolios. In other words, more (less) financially constrained firms tend to earn higher (lower) returns. This result is somewhat different from those of Lamont et al. (2001), who examine the U.S. market. Furthermore, the difference in average return between the most and least financially constrained portfolios is positive and statistically significant. However, this significant difference is observable only during up-markets and not during down-markets. To examine whether financial constraints are a priced factor, we use two kinds of test: time-series and cross-sectional. To conduct time-series tests, we regress the financial constraint factor on the factors included in the well-known factor models, such as the CAPM and Fama and French (1993) three-factor model. We construct the financial constraint factor using a zero-investment strategy based on the degree of financial constraint. The time-series regression results show that the CAPM factor does not explain the financial constraint factor, although it is satisfactorily explained by the three-factor model. This indicates that financial constraints are subsumed by the factors related to size and especially the book-to-market ratio. In the cross-sectional regression tests, we find that the coefficient estimates on the financial constraint variable are statistically insignificant. In other words, financial constraints are not priced into stock returns in Korea. In summary, we find a positive relation between financial constraints and stock returns in Korea. However, it is hard to claim that financial constraints are a priced risk. This study contributes to the literature as follows. First, we provide an alternative way to construct the financial constraints index to measure the degree of financial constraint for Korean firms. Second, this study is the first in the Korea literature to test whether financial constraints are a priced risk in Korea.

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This article investigates the relation between market’s response to corporate events and trading restrictions in a unique setting of free-bonus issues in Korea. Specifically, bonus-seeking investors face the trading restrictions that they must hold their current shares until ex-date to receive new shares, and cannot trade non-listed new shares until pay-date, while stock price is adjusted on the ex-date according to the bonus ratio. Moreover, investors face short-sale ban between the ex-date and pay-date. These trading restrictions reduce potential liquidity suppliers in the market, and it causes the excess demand for the stock. We hypothesize that the greater the trading restriction, the higher stock price. We find positive abnormal returns around both announcement date and ex-date, and strong positive relation between event returns and the degree of trading restriction measured by bonus ratio. Moreover, significant negative returns are observed near the pay-date as trading restrictions are expected to disappear. This article provides an evidence that trading restriction, which is one of market frictions, contributes to explaining the abnormal returns around corporate events.

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This study investigates the trading behavior of institutional investors in Korea. The findings of this study are as follows. First, Korean investors are just as prone to the disposition effect as U.S. investors but less overconfident than U.S. investors. Second, bond fund shows a higher disposition effect than mixed and equity funds, suggesting that conservative investors tend to delay the needed changes in their portfolio composition when new information forces them to reanalyze the situation and prospects. Third, the disposition effect is sensitive to the reference point changes. Fourth, the disposition effect is positively associated with the length of the holding period, contradicting the findings of previous studies. Finally, the disposition effect in Korea disappears after the global financial crisis, suggesting that Korean investors trade more rationally since the crisis. Our findings indicate that the disposition effect is not a universal phenomenon. The results suggest that the degree of the disposition effect is very sensitive to the type of investor groups.

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This study tests whether cumulative prospect theory (Tversky and Kahneman, 1992) captures investors’ psychological evaluations of individual stocks. It also tests the hypothesis that investors mentally evaluate a stock based on the historical distribution of returns. This study’s major empirical findings are as follows. First, when evaluated only on positive terms (henceforth TK+) of the past 36 monthly market excess returns, cumulative prospect theory value shows a negative correlation with subsequent returns. Second, a long-short portfolio sorted on TK+ earns a return of 1.197% on average per month and remains significant for six months after the portfolio’s formation. Moreover, the return predictability of TK+ remains significant even if we consider several wellknown control variables, such as beta, size, b/m ratio and momentum, and skewness-related variables. Finally, we find empirical support for the hypothesis that the probability weighting of cumulative prospect theory plays an important role in investors’ preferences for lottery-like stocks. This study demonstrates that behavioral finance can be applied to the Korean stock market using statistical analysis.

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On January 1, 2016, the Korean government began to charge capital gain taxes on KOSPI 200 derivatives securities. The background reasons for this decision are threefold. The first was to realize tax justice. The government had been taxing stock transactions, but did not tax derivatives trading until 2015. Second, the government judged that speculative trading by individual investors was excessive in Korean derivatives markets. The trading proportion of individual investors is over 30 percent, which is considerably higher than in other developed markets. Charging capital gains taxes on derivatives trading could reduce speculative trading. Lastly, a capital gains tax will increase government tax revenue. According to Hong (2012), the 10 percent tax rate will increase revenue by about 40 billion Won per year. Despite the above motives, there are some doubts that capital gains taxes increase market efficiency. Moreover, imposing capital gains taxes only on KOSPI 200 futures and options and not on underlying stock markets means that the tax justice gained is limited, and critics have noted that derivatives are mainly used as a hedging vehicle. The literature on financial taxes can be divided into two categories of focus: transaction taxes and capital gains taxes. According to the literature, the effects of taxes are different across countries and sampling periods. The overall consensus on the effect of transaction taxes is positive, but negative for capital gains taxes. In many countries, transaction taxes reduce speculative trading and ultimately increase market quality once liquidity is sufficient, whereas capital gains taxes decrease demand for securities and even distort the behavior of investors, thereby worsening market quality. However, most results are based on stock markets, not derivatives markets. Hence, those results are not applicable to Korean derivatives markets, so the effect of capital gains taxes is still unclear. This paper examines whether capital gains taxes on derivatives trading are consistent with initial intentions by investigating changes in trading volumes, traders’ proportion, and market efficiency in areas such as bid-ask spread, effective spread, and market quality. We use a difference-in-difference method to determine the net effect of capital gains taxes. The Korean derivatives market has twin KOSPI 200 index futures and options, KOPSI200 and Mini-KOSPI 200. Their economic characteristics are the same, but their multipliers are different: one is 0.5 million Won and the other is 0.1 million Won. In this study, the capital gains taxes are levied only on KOSPI 200 futures and options. In the DID analysis, we set Mini-futures and options markets as control groups. We first explore the change in trading volumes of KOSPI 200 and Mini futures and options before and after the introduction of capital gains taxes for three months. Second, we identify changes in trading proportions patterns of individual, institutional, and foreign investors. Third, we investigate bid-ask spreads, effective spreads, residual quantity, and market quality to confirm the change in market efficiency. Fourth, we study the changes in volatility spreads, i.e., the difference between VKOSPI and a 5-minute realized volatility. In addition, to ensure robustness, we conduct the above analyses again at one month before and after. Our results are summarized as follows. First, capital gains taxes affect the trading volume of KOSPI 200 futures and options negatively, which is consistent with studies such as Noronha and Ferris (1992). Second, the effect is prominent for individual investors. The proportion of individual investors in KOSPI 200 options and futures trading decreases significantly, while the proportion in Mini options and futures trading more than doubles. As a result, the proportion of domestic institutional investors also decreases. Third, the effect of capital gains taxes is different across futures and options markets. In the futures market, the capital gains tax increases the bid-ask spread and decreases the residual order quantity and market quality, but the net negative effect based on the DID analysis is insignificant. In the KOSPI 200 options market, in contrast, the net effects are significantly negative in most efficiency measures. However, the negative effects occur because the efficiency of the Mini-options market is improved by the inflows of individual investors from KOSPI 200 options to Mini options.

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The Korea Exchange (KRX) increased its multiplier for KOSPI200 options from KRW100,000 to KRW500,000 over a three-month period from March to June 2012. The rule change was intended to limit small individual traders from trading the option product. We examine how this event affected the trading patterns of various types of traders and whether it altered efficiency in information transfers between the KRX and the Eurex Exchange, the two markets in which the KOSPI200 options are cross-listed. The change in the option multiplier was motivated by the need to curb excessive speculative trading by individual traders and to secure stability in the market. The move to a five-times-larger minimum trading unit was expected to effectively drive a significant number of small investors out of the market, many of whom were believed to trade for speculation. The event is distinctive in that while most of the rule changes around the world regarding trading units involved reductions, the KRX case was in the opposite direction: an increase. Empirical studies that examine the effects of trading unit reductions demonstrate that they improve liquidity and induce positive market reactions (Amihud, Mendelson, and Uno, 1999; Ahn, Cai, Hamao, and Melvin, 2014, among others). How trading unit increases affect liquidity and pricing efficiency is an open empirical question that is both interesting and important. We attempt to answer this question. There are two conflicting views on how trading by individuals affects market efficiency. De Long, Shleifer, Summers, and Waldmann (1990) propose a model in which the unpredictability of noise traders’ beliefs adds a risk to prices, hampering the price discovery process by deterring arbitrage. If noise traders do exist in the market, no other types of investors make better candidates than individuals who trade with small amounts of capital—exactly the kind of traders who would be affected most by the KRX’s multiplier increase. If trading by individuals adds noise to prices, reduced participation by small individuals in option trading would mean improved price discovery. Other studies demonstrate that individuals’ participation in trading increases liquidity and improves price efficiency (for instance, Brennan and Copeland, 1988; Anshuman and Kalay, 2002). Because individuals are normally regarded as uninformed liquidity traders, active trading by individuals encourages informed investors to trade more. With more informed trading, price discovery improves. In a similar vein, an exogenous shock that deters individuals from entering the market reduces liquidity and the amount of informed trading, in turn reducing price discovery. Hence, the increase in the KOSPI200 options multiplier is predicted to worsen market efficiency. Our empirical results are summarized as follows. First, we find significant reductions in trading volume after the change in the multiplier for all three types of traders: individuals, domestic institutions, and foreigners. However, in contrast to our prediction that trading volume by individuals would decrease most because the rule change was intended to limit individuals’ participation in option trading, trading volume initiated by domestic institutions and foreign investors decreased by far greater magnitudes than the volume initiated by individual investors. Second, while trading volume declined for all moneyness after the change in the multiplier, it was deep out-of-the-money (OTM) options, an indicator of speculative trading, that saw the largest reduction in volume, suggesting that speculative trading diminished significantly after the multiplier had changed. The reduction in OTM options volume is particularly notable for individuals and foreigners. Finally, while efficient information transmission from Eurex trading to next-day KRX trading was evident before the increase in the multiplier, delayed transmissions were observed afterwards, suggesting that the change in the multiplier reduced efficiency in information transmission from the Eurex to KRX. We did not find any evidence that the event triggered a significant structural change in information transmission from the KRX to Eurex. Our overall results suggest that the increase in the multiplier and the resulting reduction in liquidity weakened the information linkage between the Eurex and the KRX. Our study contributes to the literature in three ways. First, despite a plethora of research on the issue, scholars still strongly debate whether individuals’ participation in trading assists or hinders price efficiency. We provide useful empirical evidence on the matter. The KRX is well known for its unusually high individual trader participation rate. Excessive individual trading have frequently been cited as the reason why KOSPI200 options maintained its position as the most actively traded derivative product in the world for more than 10 years. Because individuals dominate KOSPI200 options trading and the larger option multiplier targets individuals, we believe that the KRX event provides a rare and clear laboratory experiment that provides important evidence about the role that individuals play in price discovery. Second, our study provides useful policy implications. The multiplier change was motivated by the need for investor protection and market stabilization. However, it also brought about an unwanted side effect: deterioration of price efficiency. Our results suggest that although walking a fine line between investor protection and efficiency is always a challenging task, the authorities need to consider more refined measures that improve market efficiency without hurting the balance between the two. Lastly, our study also sheds light on the market microstructure of the Eurex global market for KOSPI200 options, which has rarely been examined.

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