Modeling the Dynamics of the Egyptian Stock Market
Mohamed Askar, Ph.D.
Associate Professor
American University in Cairo
11 Youssef El-Gindi Street
Cairo, Egypt
Email: maskar@aucegypt.edu
Ahmed Farghaly
MBA Graduate
American University in Cairo
Email: farghaly@aucegypt.edu
Maha Resk
MBA Graduate
American University in Cairo
Email: maharesk @ gmail.com
Abstract
The Egyptian stock market has been experiencing a set of fluctuations over the past
two years. This was caused by several factors that include the behavior of the
Egyptian Economy, as well as the performance of the other Middle Eastern stock
markets. In this paper we use System Dynamics as a tool for mapping the
performance of the CASE 30, Egyptian Stock market index, to identify the various
interacting feedback loops that triggered such performance. These loops are then
incorporated in a system dynamics model that is used to understand the causes of
such performance as well as developing several scenarios for managing the various
factors affecting the Egyptian stock market.
Introduction
The Egyptian stock market is among the oldest stock in the world dating back to
1883. It consists of both the Alexandria stock exchange, founded in 1883 and the
Cairo stock exchange, founded in 1940’s. However, during the 1950’s Egypt adopted
a socialist regime that resulted in a wave of nationalization which in turn deemed all
the outstanding stocks of previously traded companies obsolete, as these companies
turned state owned.
Throughout the 1990's, the Egyptian government carried out economic reform
programs that included privatization of state owned companies; liberalization of the
financial market; and adoption of market based economy. This resulted in the re-
activation of the Egyptian Stock Market, (Capital Market Law 95/1992). Further, the
Presidential Decree No. 51 for year 1997 redefined the legal structure of the
Exchanges and accordingly the Cairo and Alexandria Stock Exchanges have been
merged into one entity (The Cairo and Alexandria Stock Exchange or CASE) with
one Chairman and one Board of Directors, and two locations: Cairo and Alexandria.
Today, the Egyptian Stock market is an active market that has market capitalization of
$27,847.48, CASE Annual report 2006.
CASE 30
9,000.00
8,000.00
7,000.00
6,000.00
5,000.00
4,000.00
3,000.00
2,000.00
1,000.00
0.00
02/01/2005,
02/02/2005
06/03/2005
04/04/2005
10/05/2005
08/06/2005
07/07/2005
07/08/2005
05/09/2005,
04/10/2005
io]
= 06/12/2005
05/01/2006
13/02/2006
16/03/2006
17/04/2006
23/05/2006
21/06/2006
20/07/2006
21/08/2006
19/09/2006
19/10/2006
Figure 1 Performance of the Egyptian Stock Market in the Year 2005
As the Egyptian Stock market grew, it started attracting investors from inside and
outside Egypt, all investing in the Stock Market with the aim of maximizing the value
of their investments as well as growing their portfolios. The current growth of the
Egyptian Stock market started by the year 2003 and reached its peak in 2005.
However, after reaching its peak in 2005, the Egyptian stock market started to
experience some severe fluctuations that resulted in an awakening of the policy
makers as they tried to understand this phenomena and tried to develop policies that
will guard against such severe fluctuations in the future, figure 1.
This paper attempts to explore the factors affecting the recent fluctuations in the
Egyptian Stock market. In doing so, we selected System Dynamics as a tool for
mapping the various forces that shaped the recent performance of the Egyptian Stock
market. Such approach resulted in the development of a System Dynamics model that
is used first, to understand the forces shaping the Egyptian Stock market performance,
and second, to examine various policies that can dampen the effect of such severe
fluctuations.
The theoretical framework section of this paper presents the theoretical background
used to develop the model. Following this presentation, the model section presents the
formulation of the System Dynamics model used to explore the forces that affect the
behavior of the Egyptian Stock market. Further, the results section outlines the testing
of various policies and scenarios that are developed to understand the behavior of the
model. Finally, concluding remarks and recommendations are presented to provide
analysis of the research as well as providing recommendations for future research.
Theoretical Framework
The quest for understanding the behavior of the stock market has been examined
extensively throughout the literature. This resulted in the development of theories and
models that examine the various factors affecting the stock market performance.
Cutler et al. (1989) examined the behavior of stock markets in developed countries
and have found many forces that shape its behavior. Out of these forces are the
reaction of the stock market to the announcement of various events, Ball and Brown
(1968) ; Fama(1969) examined the reaction of the stock price to stock splits;
McConnell and Muscarella(1985) studied the impact of capital expenditures;
Klein(1986) examined the impact of divestitures; Jensen and Ruback (1983) studied
the effect of takeovers on stock pricing; Chan (2002) examined the speed of Stock
price adjustment to information.
While most of these studies examined the performance of stocks in developed
markets, little studies have been conducted to examine the performance of the stock
markets in developing countries. Among the few studies that examine the
performance of stock markets in developing countries is the study conducted by
Ignatius (1998) who examined the performance of the Bombay Stock exchange in
India.
The study of stock market behavior in developing countries requires first to
understand the factors that govern the behavior in of stock markets in developing
countries. Hess (1998) highlighted such factors as:
¢ Gross domestic product per capita substantially below the average for
developed economies.
e Greater government regulation limiting or banning foreign ownership in
domestic companies.
e A lax and/ or corrupt regulatory environment.
e Inefficient back office operations including clearing and settlement
capabilities.
e Restrictions on repatriation of initial capital, dividends, interest and capital
gains.
e Greater perceived investment risk than in developed markets and a general
perception by the investment community that the country should be considered
emerging.
e Massive privatization schemes
e Lack of investors confidence due to inadequate disclosure of companies
information
e Lack of training for financial market participants (investors, local
intermediaries, brokers)
Further, Papaioannou and Duke(1993) outlined four evolutionary stages in the
development of Stock Markets. These stages are:
1. Equity markets tend to develop only after a country has achieved a
degree of economic and political stability and begun implementing
growth- oriented policies. In this phase, equity prices tend to rise
encouraging the confidence of domestic investors. The market be
comes more widely accepted as an investment alternative to traditional
bank de posits and government securities.
2. In the second phase, because the equity market now has some degree
of credibility, pressure abroad for greater accessibility and at home for
cheaper capital funding leads to a loosening of regulations in the
domestic capital markets. As investment bafflers decline and as market
liquidity and risk- adjusted returns increase, international investors
begin to realize the diversification benefits of investing in such
markets.
3. In the third stage, the market offers the prospect of higher, less volatile
returns, and investors easily absorb new is: of stocks and bonds.
The volume of new issues increases as firms strive to pay down debt
and private or newly privatized companies make their initial public
offerings. Trading volume increases, producing greater market
efficiency, while the growing need for a risk transfer mechanism spurs
the development of equity and currency- hedging instruments such as
derivatives.
4. In the final phase, equity risk premiums fall to internationally
competitive levels relative to short-term money market rates. The
equity markets begin to achieve the stable growth that marks a mature
or developed country.
Based on these two studies, it can be argued that the Egyptian Stock market is as a
developing stock market which is currently in the second phase of development as
outlined by Papaionnou (1993) and is in the process of developing into the third stage.
Moreover, when comparing between developing and developed stock markets, it is
obvious that stock pricing in developed markets is based on market efficiency, while
developing stock markets are characterized to have weak market efficiencies,
Dockery(2000). Such weakness in market efficiencies calls for the intervention of
governments directly by imposing price limits or indirectly through securities laws
and regulations, Dockery(2000) and Phylaktis (1999).
Model Development
After presenting the theoretical framework that regulates the stock prices, we now
move to present the system dynamics model we developed to model the behavior of
the Egyptian Stock Market. The model is developed for a typical stock that is
registered in the CASE30 index. In doing so, we have developed the following
assumptions:
1. The price of the share is determined by the supply and demand for stocks. The
supply is represented by the amount of shares available for sale; sell orders.
On the other hand, demand is represented by the number of buy orders placed
to buy the shares.
2. Investors in the Egyptian Stock market are grouped into four basic categories,
namely; Local Small investors, Local Large investors, Foreign
investors(Arabs and others), and finally Government. The definition of each
class is provided as follows:
Local Small Investors: This class represents the small Egyptian investors,
individuals who invest in the stock market. This group is divided into to sub-
classes: Local Small Direct Investor, LSDI; and Local Small Indirect Investor.
The direct local small investors represents the local investors trading directly
in the stock market, and the Indirect class represents those who invest in the
stock market indirectly through financial vehicles such as mutual funds.
Local Large Investors, LLI: This class of investors represents large investors
(individuals and corporations) who invest in the stock market directly, but
because of the volume of their investments, they seek the help of qualified
financial advisors and rely on availability of information and sophisticated
technical analysis.
Foreign Investors: This class of investors represents those other than
Egyptians or Egyptian Companies investing in the Egyptian stock market. This
class is broken further into two subclasses; Arab Investors, AI, and Other
Investor, OI. The Arab investors represent those from Arabian countries,
mainly Gulf countries, investing in the Egyptian stock market. The others class
represents all other non-Egyptian nationals investing in the Egyptian stock
market.
Government: This fourth class represents the different branches of the
Egyptian Government investing in the Egyptian Stock market.
The breakdown of each class of investor, their motives, investment strategies and the
factors that affect their investment decisions are presented in table (1).
Table 1: Classification of the various investor types investing in the Egyptian Stock Market
Local Local
Small Small Local
Investor Direct Indirect Large Arab Other
Type Investor Investor Investor Investor Investor Government
Reason for | Short term | Long-term | Long-term | Portfolio Portfolio Stabilize the
Investment | profit profit profit diversification | diversification | market
and
investment of
surpluses
from oil
revenues
Reliance on | No Yes Yes Yes Yes Yes
Technical
Analysis
Ability to | Low High High High High High
sustain loss
Following the presentation of the assumptions, we now move to introduce the system
dynamics model used for mapping the Egyptian Stock market. The model is
developed in four sections: Supply-Demand and Share Price section, Buy and Sell
Transactions section, Financial Section, and Share Ownership section. The details of
how each of these sections is formulated as follows:
Supply-Demand Share Price
The first section presents the mapping of the supply-demand and their interaction with
the stock price, figure (2).The upper section of the model represents the mechanism
by which share prices change. This is achieved by mapping the share price as a stock
that is changed through the stock price change rate. This rate is expressed as a
function of the current stock price, the demand/supply ratio, share price elasticity and
the price limit. The demand supply ratio is formulated as the ratio of Demand to
Supply for the stock. The price elasticity represents how sensitive the share price is to
changes in the Demand/Supply ratio. As for the price limit, this represents the
maximum percentage imposed by the Stock Market officials for allowed stock price
changes.
The demand for shares is modeled as the total of the buy orders placed by each type of
investor investing in the Egyptian Stock market. Similarly, on the supply side, the
total supply consists of the total placed sell orders placed by the various investors
investing in the Egyptian Stock market represents the supply as well as the rate of new
share offerings placed in the Egyptian stock market. The fulfillment rate represents
the minimum of the supplied and demanded shares.
Demand Suppl
a PPE Stock Price Elasticity
Ratio
Stock Price
Change Rate
Stock Price
Se,
New Share Offering Rate Halt Trading
Sell Orders
Buy Order
Placement Rate Demay
Placement Rate
Sofi Fulfillment
Buy Fullfilmat
Sell Exit Bu Eat
Placed Sell Placed Buy Placed Buy
Orders LSDI Placed Sell Orders LSDI Orders Government
Orders Government
Placed Bi
Placed Sell Placed Sell Gases Placed Buy
Orders LSI Orders O1 ) Orders Ol
Placed Sell
Placed set be Paseo Placed Buy
Orders LLI en orders Al
Figure 2 Mapping the Supply-Demand Interaction and Stock Price
Buy/Sell Decisions
The buy/sell decision varies from one type of investor to the other. Figure (3 a-f)
present the factors used in formulating the buy/sell decisions for each investor type,
and how they are incorporated in the model. In the case of the Local Small Direct
Investor, LSDI, investment decision is initiated by the pure profit motives and
depends on:
1. Perception about the direction of the price of the stock
2. Stock price appreciation
3. and the inability of the small investor to sustain loss
The mapping of the investment decisions environment of the LSDI is modeled as
presented in figure (3-a) for both the buy and sell decisions.
In the case of the Local Large Investor, LLI, investment decisions are based on the
long-term view of the market. Further, as presented earlier, this type of investor relies
mainly on sound technical analysis and long-term growth forecasts. The strategies
employed by this type of investors are:
1. Buy low sell High strategy
. Consider the long -term stock performance
3. Have the ability to sustain short-term losses in return to long-term
gains
The technical analysis of the stock is used to determine the real value of the share
price; the maximum and minimum ranges for the price to move, as well as the long
term-forecast for the share price. This in turn has resulted in developing the mapping
of the investment decisions environment of the LLI is modeled presented in figure (3-
c). Further, a similar environment is used for mapping investment decisions made by
the Local Small Indirect Investor (professionally managed investment funds), figure
(3-b) .
The case of the Arab is presented in figure (3-d). Added to the current stock price, the
technical assessment of the stock price, the long term-forecast, another factor is
considered, the Arab Investment Funds allocated for investment in the Egyptian Stock
Market. Given all these factors combined, the mapping of the investment decisions of
the Arab investors is presented in figure (3-d).
Moving to the Other Foreign Investors, case e, investment decisions are modeled in a
similar fashion as the case of Arab investors, with one difference that is these
decisions are constrained by the funds made available for investment in the Egyptian
Stock market by the Other Foreign Investors. The mapping of such decisions is
presented in figure d.
The modeling of the last type of investor, Government Investor is presented in case e.
The Egyptian Government invests in the Stock market for two main reasons:
Stabilize the Market in the case of the market falling below its fair
value
2. Use the stock market to invest social security funds. However this type
of investment is considered as part of the Local Large Investor.
Market Performance
indicator
Das Local Small
Local Small Local Small indirect Investment
Direct Shares Indirect Shares Funds
Placed Buy Placed Sell
Orders LSDI, Orders LSDI
Placed Sel
Orders LSIP Placed Buy
ders LSII
oes | High Share Low Share
Local Small Stock Price Price i Price
Direct Investment ic) Stock Price ic)
Funds
a )Local Small Direct Decision b) Local Small Indirect Decisions
High Share Low Share
Price Price
Low Share
as Placed Buy
High Share — Price )
\
Price! Stock Price = pen orders Al
Shares
Placed Sell Placed Buy
Orders LLI Orders LLI
Arab Investment
Funds
Placed Sell
Orders Al
Local Large Local Large Demand
Shares Investment Funds Arab Funds
c) Local Large Investor d) Arab Investors
Placed Sell Govemment
Orders O! Share
Demand Others
Funds
Placed Sell
Others Investment grders Gov ernment Placed Buy
Funds Stock Pri Orders Gov ermment
faced Buy
ders OL
High Share fe Low Share Government Qty Demanded
Price Stock Price ) bice Investment Gov
Funds
f) Government
e) Others Investors
Figure 3 Mapping of Buy and Sell Decisions for each type of Investor
By incorporating these two factors, the investment decision of the Egyptian
Government is presented in figure (3-f). The buy and sell decisions are affected by the
market price, funds set aside by the Egyptian government for investment in the stock
market, and the technical analysis of the performance in terms of the price fluctuation
range, and the long-term price forecast.
Mapping the Financial Section
The final section of the model deals with the mapping and formulation of the funds
made available for investment in the Egyptian Stock market. As the buy/sell
decisions, these funds differ from one type of investor to another. The detail of how
the fund of each type of investor was formulated is presented as follows:
Local Small Investor
The funds available for investment by the Local Small Investor are divided by
their decision whether to invest directly in the stock market, or to investment
indirectly through professionally managed investment funds.
= } Market Performance
Interest Rate (fy fbdibetée
New Funds Available
for Investment for Local
Small Investors
Fulfilled Buy
Funds Out Orders LSD!
(s)
Funds used
to Buy Stocks LSDI
Local Small
Investment
Funds Increase Raby
Local Small
Direct Investment
Funds
Local Small
Investment Funds
Percentage
Local Direct Indirect
Local Small Ratlo
Indirect Investment
Rate
Stock Price
Funds Out
re Local Small
Indirect Investment Buy Stocks LSI! Fulfilled Buy
Funds Orders LSI!
Figure 4 Mapping of funds for the Local Small Investor
The percentage of direct to indirect decisions is set to a slider as changes in
this percentage represent various policy scenarios that are investigated late.
The total funds available for investment in the stock market is calculated based
on the new funds available to the local small investors, the current bank
interest rate and the market performance indicator. The mapping of local
investors’ funds is presented in figure.
Local Large Investors
The modeling of the funds invested by the Local Large Investors is presented
in figure . These funds are dependent on the funds allocated for investment by
the large investors, and the market performance rate.
xO
Local Large Local Large
Investment Fund Local Large Investment Fund
Investment 14 Increase Rate !nvestment Funds Decrease Rate
Funds LL! (E),
Stock Price
Funds Demenaded
Rate LLI
Funds Demanded
uu
. Fulfilled Sell
Orders LLI
Figure 5 Mapping of funds for the Local Large Investor
Arab Investors
The mapping of the Arab Investment funds allocated to the Egyptian Stock
market is presented in figure. The flow of Arab Investment funds is governed
by the oil revenue surpluses that have been enjoyed over the past years as well
as the Egyptian Market performance indicator. Withdrawal of these funds on
the other hand is controlled by commitments Arab Investors have to fulfill in
their home markets; primarily due to cover losses that result from fluctuations
in their stock markets.
=. Fulfilled Buy
Orders Al
Arab Investment
Increase Rate
@
XO
Funds Used to
Arab Investment
Buy Stocks Al
Arab Investment i Funds Stock Price
Fund
Arab Funds
Requested Arab Demand Withdrawal
Funds ‘Arab Funds
Fulfilled Sell
Orders Al
Figure 6 Mapping of funds for the Arab Investor
Other Investors
The mapping of the Other Investors Funds is presented in figure. The increase
rate of these funds is affected by the Egyptian Stock Market Performance
Indicator, the Country Stability Index, and New funds made available for
Investment in the Egyptian market. The decrease rate on the other hand is
affected by the market performance indicator and the country stability index.
Fulfilled Buy
Orders O1
Others Investment ihera javesiment —a, F
Buy Stocks Others Stock Price
Others Investment | Increase rate Funds a " ‘
Fund
Requested Others Others Funds
Funds Demand Others withdrawal R
Funds
Fulfilled Sell
Orders O1
Figure 7 Mapping of funds for the Others Investor
Government
The funds made available by the Egyptian Government for investment in the
stock market is modeled as presented in figure. The market performance
indicator plays as a trigger for the Government decisions. As the market
performance goes down, the Egyptian Government steps into the market in
order to stabilize prices. Further, the Egyptian Government uses the Stock
Market to invest social security funds in order to enable the future payments as
they are required.
Government
Investment
Funds Government Investment
Decrease Rate
@ Ae)
Government
Investment
mals “Fulfilled Buy
Orders
Government
ay
Stock Price
Figure 8 Mapping of funds for the Government
Share Ownership
The final part of the model deals with share ownership. Six similar stocks and flow
sub-models were developed to map the share ownership, figure ( a-c). As presented in
figures a-c, the stock that maps the shares held by each type of investor increases form
the buy orders placed by the investor multiplied by the buy fulfillment percentage.
Similarly, the stock of shares is decreased via the fulfilled sell orders flow that is
calculated as the product of the placed sell orders and the sell fulfillment rate.
Local Small
Direct Shares
Placed Buy
Orders LSDI
Fulfilled Buy
Orders LSD!
Placed Sell
} Orders LSDI
Fulfilled Sell
Orders LSDI
XO
Buy Fulfillment Percentage
} Sell Fulfillment Percentage
Placed Buy @
Orders LSI! Fulfilled Buy
Orders LSII
Local Small
Indirect Shares
Fulfilled Sell
Orders LSI ; Placed Sell
Orders LSI!
Figure9a =~ Mapping of share ownership for Local Small Direct Investors and
Local Small Indirect Investors
Placed Sell
Placed Buy tisea targe Orders LL
Orders LLI Fulfilled Buy peat Fulfilled Sell
Ordes LLI Orders LLI
Buy Fulfillment Percentage Sell Fulfilment Percentage
Fulfilled Buy ‘Arab Fulfilled Sell’
Placed Buy ‘rears Shas ‘Orders, Al Placed Sell
orders Al ! Orders Al
Figure9b = Mapping of share ownership for Local Large Investors and Arab
Investors
Placed Buy Placed Sell
Orders 01 Orders O1
Fulfilled Buy
Orders O1
Fulfilled Sell
Orders O1
@
Other Shares
Buy Fulfillment Percentage
s
©
} Sell Fulfillment Percentage
@
Fulfilled Buy
Government
Orders
Placed Buy ; Share
Government
Orders Gov ernment
Figure 9 c
Fulfilled Sell
Orders Placed Sell
re Orders Gov ernment
Mapping of share ownership for Other Investors and Government.
Results
After presenting the model, we now move to present some scenarios that illustrate the
model behavior. Three policy scenarios are presented to illustrate the behavior of the
model. These scenarios investigate the effects of the following factors; Effect of Local
Small Direct Investors, Impact of Fluctuations in the Arab Stock Markets, and
Government Intervention.
Scenario 1: Impact of Local Small Direct Investors
This scenario represents the base scenario that explains the current situation in the
Egyptian Market. As stock prices move upward, the market attracts Local Small
Direct Investors who enter the market seeking fast profit. The increased demand
generated by this type of investors’ heats up the market, driving share higher than the
high prices calculated based on the technical analysis. This in turn triggers the other
investors, (Local Large, Arab and other) to sell their stocks to capture the profits. As a
result, the supply of shares increases, leading the stock price to take a south turn. As
this happens, Local Small Direct Investors start selling their shares as they have
limited ability to sustain market loss, resulting in a bigger dive in stock prices to
levels that are considered below the low prices estimated by the technical analysis. At
this point, the market becomes more attractive to the Large investors who start to buy
stocks, hence repeating the cycle, figure 10.
r
3]
34 oO
1.00 92.00 183.00 274.00 365.00
Page 1 Days 6:33 PM Sat, Mar 24, 2007
N@eF ? Stook Price
Figure 10 Basic Scenario
In dealing with this case, we recommend an Investment Policy that encourages small
investors to seek the use of professionally managed funds that rely on sound technical
analysis and limit their direct trading in the market. The impact of this policy is
demonstrated in figure resulting in reduction of the cyclical fluctuations in the market,
figure 11.
@ 1: High Share Price 2: Low Share Price 3: Stock Price
13
2
3
183.00 274.00 366.00
Days 3:45 PM Sat, Mar 31, 2007]
‘Stock Price
Figure 11 Effect of Eliminating the effect of Local Small Direct Investors
Scenario 2: Impact of Fluctuations in the Arab Market
This scenario investigates the impact of fluctuations in Arab Stock Markets on the
Egyptian Stock Markets. As fluctuations take place in Arab markets, Arab investors
start a selling frenzy to generate funds needed to cover losses in accrued in their
markets. As this takes place, increase in supply of shares is experienced, driving the
Egyptian Stock market prices down. This then triggers other investors, especially
Local Small Direct Investors, resulting in further decrease in prices, figure 12.
3: Stock Price
2 -
3
17
4] mat | erccrmromenconsrccen pay 7 moceemeconenart -rpocrerarencenoernn EER ERRRDRRNE
4 ‘
2
3 bo —
1.00 6.25 11.50 16.75 22.00
Page 1 Days 3:49PM. Sat, Mar 31, 2007]
Naat ? Stock Price
Figure 12 Effect of Demand for Arab Funds on the Stock Market
Scenario 3: Dealing with Market Extremes
This case deals with market stabilization in the downward cycle. As the market prices
decline and approach their low end, the policy calls for the government to temporarily
intervene in the market by buying stocks. This will have two main effects namely:
e Increase confidence in the market, and stop the further decline of prices.
e¢ Make the Government profits as they will buy at very low prices that will be
transformed later to profits as the market recovers.
Stock Price
8.50 16.00 23.50 31.00
Days 3:63 PM = Sat, Mar 31, 2007)
Stock Price
Figure 13 Effect of Government Intervention on the Stock Market
Concluding Remarks
This paper presents an exploratory model for studying the Egyptian Stock Market
Dynamics. The model attempts to explain what is currently happening in the Egyptian
Stock Market in face of speculative demand for stocks. As a result the policies
presented investigate several scenarios that can be utilized in dealing with such
fluctuations in the market.
Building on this paper, the model needs to be further expanded to incorporate the
issues of risk associated with each type of investor, and the impact they will have on
the overall market performance.
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Acknowledgements
The authors would like to acknowledge Ms. Aleya Serag El-Din, Ms. Amina Haggag,
Ms. Salma Hassan and Mr. Mohamed Mofty for their valuable contribution to this
research.
