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A chaos analysis for Greek and Turkish equity markets

Alper Ozun
Bradford University, School of Management, Bradford, UK

Greek and Turkish equity markets 101

Mike P. Hanias
General Department of Applied Sciences, Technological Educational Institution (TEI) of Chalkis, Psachna Euvoias, Greece, and

Panayiotis G. Curtis
Department of Accounting, Technological Educational Institution (TEI) of Chalkis, Psachna Euvoias, Greece
Abstract
Purpose This paper sets out to apply chaos theory to the prediction of stock returns using Greek and Turkish stock index data. The aim of the analysis is to empirically show whether the markets have informational efciency, in a comparative perspective. Design/methodology/approach The research employs Grassberger and Procaccias methodology in the time series analysis in order to estimate the correlation and minimum embedding dimensions of the corresponding strange attractor. To achieve out of the sample multistep ahead prediction, the paper gives the average for overall neighbours projections of k-steps into the future. Findings The results display the fact that the chaos theory is suitable to examine the time series of stock index returns. The empirical ndings show that the stock markets are efcient in Greece, though in Turkey the market is predictable. The main practical implication of the ndings is that the technical analysis works in Turkish markets and it is possible to beat the market, while in Greece the fundamental analysis works for equity trading. Originality/value The research results have both methodological and practical originality. On the theoretical side, the research shows how the chaos theory can be applied in nancial time series analysis. The model is employed with data from Greece, as an EU member; and Turkey, as a candidate to the EU. The fact that the model works in Turkey implies that chaos theory can be used in emerging economies as a prediction model. On the practical side, the paper contributed to the previous literature by providing empirical evidence on market efciency using a stochastic model. Keywords Chaos theory, Equity capital, Stock markets, Greece, Turkey Paper type Research paper

JEL classication: G14, G17, D53, D84. Introduction Predicting stock returns is possible with different methodologies. While one group of methodologies uses parametric models, an alternative group employs nonparametric ones. The second category relies on the algorithms used in physical sciences, in general. In this research paper, we combine nance, and chaos theory from physics to examine the predictability of Greek and Turkish stock market indexes in a comparative perspective.

EuroMed Journal of Business Vol. 5 No. 1, 2010 pp. 101-118 q Emerald Group Publishing Limited 1450-2194 DOI 10.1108/14502191011043189

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We choose nancial data from Greek and Turkish markets because of the fact that though they locate on the same region, their economies move on different dynamics. Greece, as an EU member, has been stable in the past few decades; while Turkey, as an emerging economy, has experienced economic turbulences arising mostly from regulatory changes and political instability. The same methodology can produce different success records in the prediction as the time series vary. It is needless to say that another reason for choosing these economies for comparison is that the authors are from Greece and Turkey, and the reason for employing chaos theory is that the authors are from physics and nance disciplines. The reason to write the paper itself is a subject to the discussion whether happenings are just coincidences with chaotic dynamics or move in an order. The paper employs Grassberger and Procaccia (1983a, 1983b) methodology to examine if the stock markets are predictable. We use a chaotic analysis to predict index returns in the Athens Stock Exchange and the Istanbul Stock Exchange. After estimating the correlation dimension and the minimum embedding dimension, we point out that the system is a high dimensional chaotic system for the ISE while it is not so dominant in the ASE. From reconstruction of the systems strange attractors, we achieve a 10,20,30,40.50 and 100 time steps out of sample multistep prediction. The empirical ndings show that the ISE, as an emerging and chaotic market, is more predictable as compared to the ASE. The index in the Turkish market does not reect the information being available in the public. Due to some reasons (i.e. transaction costs, inefcient regulations or in general chaotic nature), the market shows inefcient information allocation. Thus, we conclude that the analysis of time series in the ISE provides excess returns for the investors. In Greece, on the other hand, the stock index is less predictable indicating higher market efciency. The paper shows that chaos theory is useful to predict stock returns though its performance depends on the nature of markets. The model used in our analysis has a good performance in detecting chaotic characteristic of the market. The prediction performance is in parallel to the degree of the chaotic nature of the market under examination. In the next part, we give a literature review and discuss the role of chaos theory in predicting nancial time series. After introducing the data, the theoretical framework which also explains the methodology is presented. In the fourth part, empirical ndings are discussed in detail. The predictive performance of the model is evaluated in a comparative perspective. The paper ends with some suggestions for future research Literature review. Stochastic models are able to produce more accurate short-term predictions as compared to deterministic models. A chaotic pattern in time series displays the fact that a minuscule error of measurement produces large prediction errors except for short term forecasts (Alexander, 2002, p. 401). Chaos theory in nancial time series is rstly used by Takens (1981) who shows that if the system has chaotic dynamics, a fractal dimension governs the time series. The early empirical results on existence of chaos in the nancial markets are contradictory. Medio (1992) argues that the markets are ruled by a chaotic order, and therefore, in the short term they have informational inefciency. On the other hand,

Hsieh (1991), Alexander and Giblin (1994) and Abhyankar et al. (1997) present empirical evidence that the markets do not show any chaotic patterns. The chaos theory in nance is tested by two groups of methods, namely nearest neighbour methods and multivariate embedding methods (Alexander, 2002, pp. 403-405). Nearest neighbour methods that will be explained later in detail are employed in nance by Alexandre et al. (1998) who predict exchange rates using time-delay embeddings; Finkenstadt and Kuhbier (1995) using the method for prediction of commodity prices. Alexander and Giblin (1997) enrich the nearest neighbour method by constructing a multivariate nearest neighbour prediction method. Using high-frequency data, they empirically show that the chaos in nancial markets can be detected under multivariate model. A broad literature review on multivariate embedding methods can be found in Alexander (2002). Additional related literature will be presented in the part of theoretical framework. In applied nance, technical analysis argues that price dynamics can be estimated with linear trends and examined by statistical approach. By analysing certain technical indicators, investors are able to predict the future prices of nancial instruments. On the other hand, the high number of factors that affects the market dynamics and the complex nature of Markets make technical analysis not so useful. The increasing complexity of market dynamics requires more complex methodologies that are able to capture the multivariate relationships between the variables in the marketplace. Peitgen et al. (2004) argues that deterministic chaos theory suggests a trade-off to set up xed rules to link future dynamics to observed values of a nancial time series without imposing strict assumptions. The chaos theory states that stock returns and complex behaviours of the markets can be explained by using certain combinations of easily understandable approaches. In that sense, our analysis also follows that catastrophe approach arguing that chaotic trends can be investigated by certain trends that represent attractors for the nancial time series under examination. As an alternative to randomness analysis, another way of examining chaotic nature in the nancial markets is the fractal dimension in the stock returns. Existence of long term memory in stock returns is also considered as a proof of informational inefciency in the market place. The fractal approach usually employs wavelet based integration and causality analysis that are introduced to the nancial literature by Jensen (1999, 2000), Jensen and Whitcher (2000) and Whitcher and Jensen (2000). Tkacz (2001), Gencay et al. (2002) and Vourenmaa (2004) display the fact that wavelet based long-term memory effect model performs better than causality tests. In addition, Jin et al. (2006) provide empirical evidence that wavelet based models capture the abnormal results of alternative models dealing with long-term memory in stock prices. Recent nance literature shows that there exists an important level of interest in using chaos theory in predicting stock returns. Lillo and Farmer (2004), for example, examine the informational efciency of nancial markets with the long memory effect. Assaf and Cavalcante (2005) employ chaos theory to analyze the return behaviours of Brazilian stock market and conclude that stock returns show long range dependence. Mucley (2004), in his empirical paper, provides evidence for major world indices that asset return distributions move in a culprit chaos. Pandey et al. (1998) detect

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deterministic non-linearity in the stock returns of major European equity markets. Academic works on examining efciency of the Istanbul Stock Exchange with chaos theory is restricted. Ozun (1999) uses chaos theory in Istanbul Stock Exchange and empirically shows that it has informational efciency in semi-strong form. Ozun and Cifter (2008) examine the chaotic nature of Istanbul Stock Exchange using chaotic and conventional unit root tests and try to show if wavelets as an approach in the chaos theory captures long-memory better than conventional techniques. Ozun and Cifter (2008) compare the performances of Haar and Daubechies as wavelet based OLS estimator and GPH and other classical models, and show that Daubechies wavelet analysis provide the accurate determination for long memory where conventional techniques do not. As a practical implication, they argue that the returns in Istanbul Stock Exchange are predictable as long-memory exists in prices. Recent empirical evidence on implication of chaos theory in nancial time series prediction comes from works of Mike P. Hanias. First, Hanias et al. (2006) present a guide of how fractals and chaos are used in time series prediction. Hanias et al. (2007) presents empirical evidence on how chaos theory can be used for prediction stock returns in the Athens Stock Exchange. Hanias et al. (2008) also employ chaos theory to show if the Istanbul Stock Exchange has chaotic dynamics. In this paper, we provide a comparative evidence on the efciency of Greek (Athens Stock Exchange) and Turkish (Istanbul Stock Exchange) by using chaos theory with extended sample period. The paper has both theoretical and practical implications that are discussed in the conclusion part at the end. In this research paper, we employ chaos theory to estimate the correlation and minimum embedding dimensions of the corresponding strange attractor in the Istanbul Stock Exchange and Athens Stock Exchange from 5 January 1998 to 2 October 2007. The contribution of this paper into literature is to show how the model works in different economies, and produce contradictory evidence. The empirical evidence has success to show that the performance of the model depends on how the market under examination is efcient. Data We use daily closing values of Athens Stock Exchange (ASE) and Istanbul Stock Exchange (ISE) stock indexes. The sample period for the analysis is from 5 January 1998 to 2 October 2007. The data for the ASE and the ISE cover 2,437 and 2,419 daily samples, respectively. The difference in sample size is due to holiday periods, and do not create any defects in empirical results (Figure 1). Theoretical framework For a scalar time series, in our case the Athens Stock Exchange and Istanbul Stock Exchange, the phase space can be reconstructed using the methods of delays. The basic idea in the method of delays is that the evolution of any single variable of a system is determined by the other variables with which it interacts. Information about the relevant variables is thus implicitly contained in the history of any single variable. On the basis of this an equivalent phase space can be reconstructed by assigning an element of the time series xi and its successive delays as coordinates of a new vector ~ time series X.

~ To construct a vector Xi , i 1 to N, in the m dimensional phase space we use Equation 1 proposed by Takens (1981) and Kantz and Schreiber (1997): ~ Xi xi ; xi2t ; xi22t ; . . . xi2m21t 1

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~ Xi represents a point to the m dimensional phase space in which the attractor is embedded each time, where t is the time delay t iDt. The element xi represents a value of the examined scalar time series in time, corresponding to the i-th component of the time series. The dimension m of the reconstructed phase space is considered as the sufcient dimension for recovering the object without distorting any of its topological properties, thus it may be different from the true dimension of the space where this object lies. Use of this method reduces phase space reconstruction to the problem of proper determining suitable values of m and t. The next step is to nd time delay t and embedding dimension (m) without using any other information apart from the historical values of the indices. This is why the methodology is labelled as a stochastic one. We can calculate the time delay by using the average mutual information presented in Equation 2 (Fraser and Swinney, 1986; Abarbanel, 1996). With this method, we have: ! X P xi ; xit P xi ; xit log 2 I t 2 P xi P xit xi ;xit In the equation, P(xi) is the probability of value xi and P xi ; xit denotes joint probability. It shows the information (in bits) being extracted from the value in time xi about the value in time xit . The time delay is calculated as the rst minimum of the mutual information (Kantz and Schreiber, 1997). Mutual information against time delays (24 time steps) for the time series of Greek and Turkish markets are presented in Figure 2. With the above method we found the t as the time necessary to cancel the correlation between two time series values to be 24 time steps. The second step is determining the presence of chaotic behaviour. One method to determine the presence of chaos uses a fractal dimension, which will be non integer for

Figure 1. Time series of Athens Stock Index and Istanbul Stock Exchange (5 January 19982 October 2007)

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Figure 2. Mutual Information (I) and time delay (t) for the ASE and the ISE, respectively

chaotic systems. Even though there exists a number of denitions for the dimension of a fractal object (Box counting dimension, Information Dimension, etc.), the correlation dimension was found to be the most efcient for practical applications. Following Grassberger and Procaccia (1983a, 1983b) methodology, we rst calculate the correlation integral for the time series for lim r!0 and N!1 by using the Equation (3) (Kantz and Schreiber, 1997): C m r 1
N X

N pairs i1;ji1

  ~ ~ H r 2 kXi 2 XJ k

~ ~ In the equation, the summation counts the number of pairs Xi 2 XJ for which the ~ ~ distance, (Euclidean norm), kXi 2 XJ k is less than r, in an m dimensional Euclidean space.  H the Heaviside step function, with H(u) 1 for u . 0, and H(u) 0 for ,where is ~ ~ u r 2 kXi 2 XJ k , N denotes the number of points and expressed in Equation (4): N pairs 2 N 2 m 12 4

and r is the radius of the sphere cantered on Xi or Xj. If the time series is characterized by an attractor, then for positive values of r the correlation function is related to the radius with a power law C m r , ar v where a is a constant the correlation dimension and n is the correlation exponent or the slope of the lnCm(r) versus ln(r) plot. Since the data set will be continuous, r cannot get to close to zero. To handle this situation, one plots lnCm (r) versus lnr and selects the apparently linear portion of the gure. The slope of this portion will approximate n. Practically, one computes the correlation integral for increasing embedding dimension m and calculates the related n (m) in the scaling region. Using value t 24 as an optimum delay time, we reconstruct the phase space. The correlation integral C(r), by denition is the limit of correlation sum of Equation 3 for embedding dimensions m 1..10 as shown in Figure 3. In Figure 4, the slopes (v) of the lower linear parts of these double logarithmic curves give information characterizing the attractor for the ASE and the ISE.

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Figure 3. The correlation integral and lnr for different embedding dimensions (Greek and Turkish markets, respectively)

The corresponding slopes tend to saturate, for higher ms at non-integer value v 2.17. With this value of v the minimum embedding dimension is m 3. According to Kantz and Schreiber (1997) the embedding dimension m 5 based to rule m . 2v 1 was used for the state space reconstruction and gives better results than m 3 or 6. For the optimum number of nearest neighbours after several trials we found that number of 4 gave the better results. For the Turkish market, v is 2.35 (Figure 5). The minimum embedding dimension is 3 as it is for Turkish market. In other words, the smallest dimension that contains the attractor is 3. Sprott (2003) shows that 2m is enough for the embedding dimension to be 6. In that framework, the minimum embedding dimension of the attractor for one to one embedding is 3 or 6 and it depends on the optimum prediction.

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Figure 4. The corresponding slopes and scaling region of Figure 3 for the Greek market

Figure 5. The corresponding slopes and scaling region of Figure 3 for the Turkish market

Empirical evidence The predictability of a time series using phase space techniques can be considered as a test for the deterministic nature of the system. These prediction techniques have been based on the fact that nearby trajectories, either converge or do not diverge fast enough for small sample steps in the phase space. In that part, we try to predict the Athens Stock Exchange and Istanbul Stock Exchange and discuss the performance of chaos theory in a comparative perspective. We followed Stam et al. (1998) and Miksovsky and Raidl (2007) and calculated weighted average of evolution of close neighbours of the predicted state in the reconstructed phase space. The reconstructed m-dimensional signal projected into the state space can exhibit a range of trajectories, some of which

have structures or patterns that can be used for system prediction and modelling. To predict k steps into the future from the last m-dimensional vector point{xm }, we should N nd all the nearest neighbours {xm } in the 1-neighbourhood of this point. Let B1 xm NN N be the set of points within 1 of {xm } (i.e. the 1-ball). Thus any point in B1 xm is closer N N to {xm } rather than1. All these points {xm } come from the previous trajectories of the N NN system and hence we can follow their evolution k-steps into the future{xm k }. This NN evolution depends on the shape of corresponding strange attractor. The nal prediction m for the point {xN } is obtained by averaging over all neighbours projections k-steps into the future. The number of k depends on how the stretching and folding is done. The methodology is expressed in Equation (5): {xmk }  N  X 1  xm NN B[ xm  X m [B[ xm k NN
NN NN

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Figure 6. Actual and predicted time series for k 10 time steps ahead

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Figure 7. Actual and predicted time series for k 20 time steps ahead

  In the Equation,  B[ xm  is the number of nearest neighbours in the neighbourhood NN of the point {xm } (Kantz and Schreiber, 1997). {xm } represent the last known sample, N N from which we want to predict one and two steps into the future. Actual and predicted time series for k 10,20,30,40,50 and 100 time steps ahead are presented in Figures 6-11. The prediction error is analyzed with the root mean square error (RMSE). Figure 12 shows a growing error with increasing prediction horizon from k 10 to k 100 steps ahead for the ISE. On the other hand, for the ASE, the error does not move in accordance with prediction horizon. Empirical ndings in Figure 12 point out the fact that the RMSE for the ISE is lower than that for the ASE. That gives an important clue for the efciency of the

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Figure 8. Actual and predicted time series for k 30 time steps ahead

nancial markets in a comparative way. The low RMSE for the ISE implies the fact that the market is predictable, so has informational inefciency. As an emerging market, the ISE shows chaotic patterns which can be detected by using methodology explained in our paper. As analysis of historical data is alone enough to predict the returns in the market, the prices do not reect the public information exactly. On the other hand, the ASE having relatively higher RMSE is less predictable indicating that it is an advanced market in terms of information efciency. In Table I, we present some original and predicted values for k 30 time steps ahead for the ASE and the ISE. Practical implications, restrictions and suggestions for future research In this comparative research paper, we use a chaotic analysis to predict index returns in the Athens Stock Exchange and the Istanbul Stock Exchange. After estimating the correlation dimension and the minimum embedding dimension, we point out that the system is a high dimension chaotic system for the ISE while it is not so dominant in

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Figure 9. Actual and predicted time series for k 40 time steps ahead

the ASE. From reconstruction of the systems strange attractors, we achieve a 10,20,30,40.50 and 100 time steps out of sample multistep prediction. The empirical ndings show that the ISE, as an emerging and chaotic market, is more predictable as compared to the ASE. The index in the Turkish market does not reect the information being available in the public. Owing to some reasons (i.e. transaction costs, inefcient regulations or in general chaotic nature), the market shows inefcient information allocation. Thus, we conclude that the analysis of time series in the ISE provides excess returns for the investors. In Greece, on the other hand, the stock index is less predictable, indicating higher market efciency. The paper shows that chaos theory is useful to predict stock returns though its performance depends on the nature of the market. The model used in our analysis has a good performance in detecting chaotic characteristics of the market. The prediction

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Figure 10. Actual and predicted time series for k 50 time steps ahead

performance is in parallel to the degree of the chaotic nature of the market under examination. Apart from providing recent evidence on chaos theory in the nance literature, the paper also inherits certain practical implications for market participants. First, empirical ndings show that the Greek nancial market has weak-form efciency, as we are not able to predict its returns. On the other hand, Turkish market is not efcient even in the weak-form. Its returns can be predicted by using its past values. In other words, though Greek market exhibits randomness in its returns, the Turkish stock market moves in a chaotic and predictable order. The investors can use those empirical ndings for their practical analysis and decisions. They should use technical analysis, which argue that excess earning is possible by examining past values of the returns, when they invest on Istanbul Stock Exchange. On the other hand, they should follow fundamental analysis rather than technical analysis if they invest their portfolio on Athens Stock Exchange. As prices in Athens Stock Exchange are memoryless, it is not

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Figure 11. Actual and predicted time series for k 100 time steps ahead

useful to examine their past prices to detect arbitrage opportunities arising from mispricing of the past prices in the markets. We can also reach another important practical conclusion from the empirical results which is that Istanbul Stock Exchange as an emerging (and chaotic) market has still moved within instability or turbulences while Athens Stock Exchange operating in the EU zone shows stability and informational efciency. It should be kept in mind that informational efciency emerges as a result of nancial and political stability and well-established regulations. In that sense, the results of this paper has also another practical implication that regulations and stability are essentials for an efcient nancial market. Before conclusion, it should be emphasized that there are also some limitations of our research. First of all, it is worth to consider that we use daily stock returns in our empirical analysis. The chaos theory might produce more promoting results when it is

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Figure 12. RMSE for the predictions (The ASE and the ISE, respectively)

applied with intraday data which shows more nonlinearity in the returns. In that sense, the results and implications for especially Athens Stock Exchange should be considered with that restriction. Another important limitation of our paper is that the sample period consists of the 2001 crisis period for the Turkish economy where speculative attacks on Turkish Lira resulted in over a 100 percent devaluation. The results might change if the crisis period is excluded from the sample period. An essential analysis with chaos theory as a future research might concentrate on the pre and post crisis periods to see both the performance of the approach and whether the practical implications differ between two periods. On the methodological side, the future research may concentrate on alternative models for predicting stock returns in a comparative way. For example, the performance of the approach in this paper can be compared to that of wavelet-based chaos analysis. In addition, to reect the time-scaling effects in prices, wavelet theory can be combined with chaos theory in predicting stock index returns.

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ASE 4,858.27 4,863.35 4,819.32 4,791.46 4,838.51 4,823.04 4,846.08 4,861.79 4,892.97 4,922.98 4,978.57 4,972.34 4,996.48 5,024.85 5,032.19 5,103.47 5,101.09 5,123.36 5,134.69 5,140.32 N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A

P(ASE) 4,870.35 4,888.21 4,841.34 4,855.49 4,937.98 4,830.43 4,817.03 4,808.75 4,826.43 4,967.77 4,942.31 4,842.56 5,018.05 5,128.48 5,121.04 5,114.73 5,075.07 5,117.01 5,041.89 5,104.11 5,051.12 4,941.69 4,991.73 4,937.89 4,948.5 4,947.4 4,909.28 4,830.91 4,831.18 4,823.62 4,869.31 4,868.72 4,996.98 5,001.38 4,935.67 4,998.85 4,935.81 4,946.73 4,907.4 4,817.51 4,819.33 4,740.57 4,809.74 4,812.1

ISE 49,601 49,538 48,548 49,296 49,161 49,106 50,620 50,536 50,500 53,884 53,543 53,882 53,580 52,893 54,245 54,390 54,044 54,198 54,733 N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A

P(ISE) 49,939.5 49,289.2 48,546.8 49,329.9 49,544 49,279.7 49,400.7 50,677.1 51,643 52,584.5 52,233.4 53,334.3 54,123.6 53,395.4 53,374.2 54,083.5 53,759.9 54,226.6 54,146.3 53,946.4 54,392.8 54,312.6 54,357 54,250.2 54,271.1 54,271.4 53,575.4 53,535.5 53,699.8 53,556.8 53,580.6 52,821.4 53,549.8 52,856 53,545.7 53,588.5 51,640 53,524.3 53,586.6 51,084.1 49,661.2 49,700.1 49,722.5 49,643

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Table I. Some original and predicted values for k 30 time steps ahead for the ASE and the ISE

Notes: N/A means that we have not actual values for this time period. P denotes prediction

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