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1. Introduction
Changes in the composition of the index are an exclusive opportunity to examine the price and volume pattern for companies getting included to/excluded from the index. Inclusion (exclusion) of a stock to a benchmark index not only affects the stock price and volume of shares traded, but also reveals many other kinds of information about the companies. At a broad level, the effect of index change on companies is known as "index effect." Many studies have been undertaken, and a number of hypotheses have been tested by researchers in relation to index effect. These hypotheses are Downward Sloping Demand Curve (DSCD) hypothesis, Price Pressure Hypothesis (PPH), Liquidity Cost Hypothesis (LCH), Information Content Hypothesis (ICH) and Market Segmentation/Investor Recognition Hypothesis (IRH).
DSDC hypothesis assumes that, different stocks are not close substitutes in the knowledge of investors. When a specific stock experiences increasing (decreasing) demand shocks, then the price and volume tend to move upward (downward) to a new equilibrium. Applying this to index effect, a permanent increase (decrease) in price and volume can be expected following an index revision. PPH posits that, the increase (decrease) in price and volume should be associated with increased buying (selling) of a stock in the short run. Hence, the price and volume will increase for included stocks and will decrease for excluded stocks. However, the DSDC hypothesis differs from the PPH based on the duration of inclusion/exclusion effect on price and volume. The DSDC hypothesis posits that, the change in price is permanent whereas the PPH posits that the change in price is temporary, and an immediate reversal will follow. Both the hypotheses assume that the information effects probably have no role to play. LCH states that, stocks included to the index become economical for investors to trade since there is increase in liquidity, and decrease in transactions costs. Inclusion leads to more frequent trading and reduction in trading costs of a stock, while the exclusion causes the reverse. ICH says that index inclusion or exclusion reveals new information which is beneficial to the investors, which in turn affects the stock prices permanently. IRH posits that new competent investors are drawn towards the firm by market-attracted information leading to a permanent stock price appreciation. When the inclusion of...