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Examining Market Efficiency In Capital Market Theory

The term market efficiency in capital market theory is used to explain the degree to which stock prices reflect all available, relevant information. The concept of Efficiency Market Hypothesis (EMH) is based on the arguments put forward by Samuelson (1965) that anticipated price of an asset fluctuate randomly. Fama (1970) presented a formal review of theory and evidence for market efficiency and subsequently revised it further on the basis of development in research (Fama 1991). Efficiency of equity markets has important implications for the investment policy of the investors.

The efficient market hypothesis is related to the random walk theory. The idea that asset prices may follow a random walk pattern was introduced by Bachelier in 1900 (Poshakwale 1996). The random walk hypothesis is used to explain the successive price changes which are independent of each other. The concept of Efficiency Market Hypothesis (EMH) is based on the arguments put forward by Samuelson (1965) that anticipated price of an asset fluctuate randomly. Fama (1970) presented a formal review of theory and evidence for market efficiency and subsequently revised it further on the basis of development in research he classifies market efficiency into three forms - weak, semi-strong and strong.

In its weak form efficiency, equity returns are not serially correlated and have a constant mean. If market is weak form efficient, current prices fully reflect all information contained in the historical prices of the asset and a trading rule based on the past prices cannot be developed to identify miss-priced assets.

Market is semi-strong efficient if stock prices reflect any new publicly available information instantaneously. There are no undervalued or overvalued securities and thus, trading rules are incapable of producing superior returns. When new information is released, it is fully incorporated into the price rather speedily.

The strong form efficiency suggests that security prices reflect all available information, even private information. Insiders profit from trading on information not already incorporated into prices. Hence the strong form does not hold in a world with an uneven playing field.

International Business & Economics Research Journal – March 2007 Volume 6, Number 3 57 Weak Form Efficiency In Indian Stock Markets Rakesh Gupta, (E-mail: r.gupta@cqu.edu.au), Central Queensland University, Australia Parikshit K. Basu, (E-mail: pbasu@csu.edu.au), Charles Sturt University, Australia

Studies testing market efficiency in emerging markets are few.

Poshakwale (1996) showed that Indian stock market was weak form inefficient he used daily BSE index data for the period 1987 to 1994.

Barua (1987), Chan, Gup and Pan (1997) observed that the major Asian markets were weak form inefficient.

Similar results were found by Dickinson and Muragu (1994) for Nairobi stock market

Cheung et al (1993) for Korea and Taiwan

Ho and Cheung (1994) for Asian markets.

Barnes (1986) showed a high degree of efficiency in Kuala Lumpur market. Groenewold and Kang (1993) found Australian market semi-strong form efficient.

Some of the recent studies, testing the random walk hypothesis (in effect testing for weak form efficiency in the markets) are; Korea (Ryoo and Smith, 2002; this study uses a variance ratio test and find the market to follow a random walk process if the price limits are relaxed during the period March 1988 to Dec 1988), China, (lee et al 2001; find that volatility is highly persistent and is predictable, authors use GARCH and EGARCH models in this study), Hong Kong (Cheung and Coutts 2001; authors use a variance ratio test in this study and find that Hang Seng index on the Hong Kong stock exchange follow a random walk), Slovenia (Dezlan, 2000), Spain (Regulez and Zarraga, 2002), Czech Republic (Hajek, 2002), Turkey (Buguk and Brorsen, 2003), Africa (Smith et al. 2002; Appiah-kusi and Menyah, 2003) and the Middle East (Abraham et al. 2002; this study uses variance ratio test and the runs test to test for random walk for the period 1992 to 1998 and find that these markets are not efficient).

Weak-form market efficiency in European emerging and developed stock markets

ANDREW C. WORTHINGTON and HELEN HIGGS*

School of Economics and Finance, Queensland University of Technology, Brisbane, Australia

Paper provided by School of Economics and Finance, Queensland University of Technology in its series School of Economics and Finance Discussion Papers and Working Papers Series with number 159.

Evidence on Weak Form Efficiency

and Day of the Week Effect in

the Indian Stock Market

SUNIL POSHAKWALE*

FINANCE INDIA

Vol. X No. 3, September 1996

Pages— 605-616

International Business & Economics Research Journal – March 2007 Volume 6, Number 3 57 Weak Form Efficiency In Indian Stock Markets Rakesh Gupta, (E-mail: r.gupta@cqu.edu.au), Central Queensland University, Australia Parikshit K. Basu, (E-mail: pbasu@csu.edu.au), Charles Sturt University, Australia

Faculty of Commerce

Faculty of Commerce - Papers

University of Wollongong Year 2006

Weak-Form Market E_ciency in Asian

Emerging and Developed Equity

Markets: Comparative Tests of Random

Walk Behaviour

A. C. Worthington_ H. Higgsy

The Pakistan Development Review

45 : 4 Part II (Winter 2006) pp. 1029–1040

Stock Market Volatility and Weak-form Efficiency:

Evidence from an Emerging Market

ABID HAMEED and HAMMAD ASHRAF*

If the equity market in question is efficient researching to find miss-priced assets will be a waste of time. In an efficient market, prices of the assets will reflect markets best estimate for the risk and expected return of the asset, taking into account what is known about the asset at the time. Therefore, there will be no undervalued assets offering higher than expected return or overvalued assets offering lower than the expected return. All assets will be appropriately priced in the market offering optimal reward to risk. Hence, in an efficient market an optimal investment strategy will be to concentrate on risk and return characteristics of the asset and/or portfolio. However, if the markets were not efficient, an investor will be better off trying to spot winners and losers in the market and correct identification of miss-priced assets will enhance the overall performance of the portfolio Rutterford (1993). EMH has a twofold function - as a theoretical and predictive model of the operations of the financial markets and as a tool in an impression management campaign to persuade more people to invest their savings in the stock market (Will 2006). The understanding of efficiency of the emerging markets is becoming more important as a consequence of integration with more developed markets and free movement of investments across national boundaries. Traditionally more developed Western equity markets are considered to be more efficient. Contribution of equity markets in the process of development in developing countries is less and that resulted in weak markets with restrictions and controls (Gupta, 2006) In the last three decades, a large number of countries had initiated reform process to open up their economies. These are broadly considered as emerging economies. Emerging markets have received huge inflows of capital in the recent past and became viable alternative for investors seeking international diversification. Among the emerging markets India has received it‟s more than fair share of foreign investment inflows since its reform process began. One reason could be the Asian crisis which affected the fast developing Asian economies of the time (also some times collectively called „tiger economies‟). India was not affected by the Asian crisis and has maintained its high economic growth during the period (Gupta and Basu 2005).

The efficient market hypothesis is related to the random walk theory. The idea that asset prices may follow a random walk pattern was introduced by Bachelier in 1900 (Poshakwale 1996). The random walk hypothesis is used to explain the successive price changes which are independent of each other. Fama (1991) classifies market efficiency into three forms - weak, semi-strong and strong. In its weak form efficiency, equity returns are not serially correlated and have a constant mean. If market is weak form efficient, current prices fully reflect all information contained in the historical prices of the asset and a trading rule based on the past prices can not be developed to identify miss-priced assets. Market is semi-strong efficient if stock prices reflect any new publicly available information instantaneously. There are no undervalued or overvalued securities and thus, trading rules are incapable of producing superior returns. When new information is released, it is fully incorporated into the price rather speedily. The strong form efficiency suggests that security prices reflect all available information, even private information. Insiders profit from trading on information not already incorporated into prices. Hence the strong form does not hold in a world with an uneven playing field. Studies testing market efficiency in emerging markets are few. Poshakwale (1996) showed that Indian stock market was weak form inefficient; he used daily BSE index data for the period 1987 to 1994. Barua (1987), Chan, Gup and Pan (1997) observed that the major Asian markets were weak form inefficient. Similar results were found by Dickinson and Muragu (1994) for Nairobi stock market; Cheung et al (1993) for Korea and Taiwan; and Ho and Cheung (1994) for Asian markets. On the other hand, Barnes (1986) showed a high degree of efficiency in Kuala Lumpur market. Groenewold and Kang (1993) found Australian market semi-strong form efficient. Some of the recent studies, testing the random walk hypothesis (in effect testing for weak form efficiency in the markets) are; Korea (Ryoo and Smith, 2002; this study uses a variance ratio test and find the market to follow a random walk process if the price limits are relaxed during the period March 1988 to Dec 1988), China, (lee et al 2001; find that volatility is highly persistent and is predictable, authors use GARCH and EGARCH models in this study), Hong Kong (Cheung and Coutts 2001; authors use a variance ratio test in this study and find that Hang Seng index on the Hong Kong stock exchange follow a random walk), Slovenia (Dezlan, 2000), Spain (Regulez and Zarraga, 2002), Czech Republic (Hajek, 2002), Turkey (Buguk and Brorsen, 2003), Africa (Smith et al. 2002; Appiah-kusi and Menyah, 2003) and the Middle East (Abraham et al. 2002; this study uses variance ratio test and the runs test to test for random walk for the period 1992 to 1998 and find that these markets are not efficient).

Study of the stock return generating process has long been dominated by interest in its random walk properties. Justification for such interest is not hard to find, given that the presence (or absence) of a random walk has important implications for investors and trading strategies, fund managers and asset pricing models, capital markets and market efficiency, and consequently financial and economic development as a whole. Trading strategies, for example, differ when returns are characterised by random walks or by positive autocorrelation (or persistence) over short horizons and negative autocorrelation (or mean reversion) over long horizons. In this instance, and as the investment horizon lengthens, an investor would invest more (less) in stocks if the relative risk aversion is greater (less) than unity, than if the returns were serially independent. Similarly, random walks in stock returns are crucial to the formulation of rational expectations models and the testing of (weak-form) market efficiency. In an efficient market the prices of stocks fully incorporate all relevant information and hence stock returns will display unpredictable behaviour. In stock prices not characterised by a random walk, the return generating process is dominated by a temporary component and therefore future returns can be predicted by the historical sequence of returns. Lastly, the ability of stock markets to play the role that is ascribed to them – attracting foreign investment, boosting domestic saving and improving the pricing and availability of capital – depends upon the presence of random walks. A market following a random walk is consistent with equity being appropriately priced at an equilibrium level, whereas the absence of a random walk infers distortions in the pricing of capital and risk. This has important implications for the allocation of capital within an economy and hence overall economic development.

This paper examines the random walk behaviour of a large number of Asian emerging and developed markets. Past studies of random walks and market efficiency in Asian equity markets have tended to focus on a single, often developed, market [see, for example, Groenewold and Kang (1993), Ayadi and Pyun (1994), Lian and Leng (1994), Huang (1995), Groenewold and Ariff (1998), Los (2000), Lee et al. (2001) and Ryoo and Smith (2002)]. The current analysis also includes a number of alternative, though complementary, testing procedures. With few exceptions, previous research has relied upon a single, often inexact, testing procedure [see, for instance, Poshakwale (1996), Karemara et al. (1999), Ryoo and Smith (2002) and Abraham et al. (2002)]. Finally, this paper uses daily data to detect violations of the random walk hypothesis likely to be obscured at longer sampling frequencies. Nearly all earlier work has specified returns as weekly or longer [see, for example, Karemara et al. (1999), Los (2000), Abraham et al. (2002)]. The remainder of the paper is divided into four main areas. Section 2 provides a description of the data employed in the analysis. Section 3 discusses the empirical methodology used. The results are dealt with in Section 4. The paper ends with some concluding remarks in Section 5.

Efficient markets hypothesis (EMH) asserts that in an efficient market price fully reflect available information. This implies that investor can expect to earn merely risk adjusted return from an investment as prices move instantaneously and randomly to any new information. Efficiency is defined at three different levels, according to the level of information reflected in the prices. Three levels of EMH are expressed as follows: weakform, semi-strong and strong form. Weak-form version of EMH asserts that prices of financial assets reflect all information contained in the past prices. Semi-strong version postulates that prices reflect all the publicly available information. Lastly, strong-form posits that prices of financial assets reflect, in addition to information on past prices and publicly available information, inside information [Fama (1970, 1991)].

Weak-form market efficiency in European emerging and developed stock markets

ANDREW C. WORTHINGTON and HELEN HIGGS*

School of Economics and Finance, Queensland University of Technology, Brisbane, Australia

Paper provided by School of Economics and Finance, Queensland University of Technology in its series School of Economics and Finance Discussion Papers and Working Papers Series with number 159.

Evidence on Weak Form Efficiency

and Day of the Week Effect in

the Indian Stock Market

SUNIL POSHAKWALE*

FINANCE INDIA

Vol. X No. 3, September 1996

Pages— 605-616

International Business & Economics Research Journal – March 2007 Volume 6, Number 3 57 Weak Form Efficiency In Indian Stock Markets Rakesh Gupta, (E-mail: r.gupta@cqu.edu.au), Central Queensland University, Australia Parikshit K. Basu, (E-mail: pbasu@csu.edu.au), Charles Sturt University, Australia

Faculty of Commerce

Faculty of Commerce - Papers

University of Wollongong Year 2006

Weak-Form Market E_ciency in Asian

Emerging and Developed Equity

Markets: Comparative Tests of Random

Walk Behaviour

A. C. Worthington_ H. Higgsy

The Pakistan Development Review

45 : 4 Part II (Winter 2006) pp. 1029–1040

Stock Market Volatility and Weak-form Efficiency:

Evidence from an Emerging Market

ABID HAMEED and HAMMAD ASHRAF*

CONCLUSION

The results of this analysis are consistent with the generalisation that emerging markets are unlikely to be associated with the random walks required for the assumption of weak-form market efficiency. However, Hungary, as the most institutionally mature of these markets, does satisfy this criterion. However, the evidence regarding developed markets is less conclusive with some markets following random walks while others do not. It is not difficult to rationalize why equity markets in Germany and the United Kingdom are weak form efficient; it is rather less easy to do so for the smaller markets of Ireland, Portugal and Sweden. This presents an interesting avenue for future research, as does the attempt to examine whether market efficiency has improved over time in any or all of these markets.

Nonetheless, the results pleasingly indicate that the various tests for random walks, often encompassing more and less stringent criteria and assumptions, provide generally consistent evidence on the presence of random walks. This should provide some reassurance to future empirical researchers in this area.

In this paper an attempt has been made to model the volatility of stock returns for the Pakistani stock market and to test for weak-form efficiency. Results point out that returns exhibit persistence and volatility clustering. Weak-form efficiency hypothesis is rejected as it is found that past information helps in predicting future prices. Mean variance hypothesis does not hold for Pakistani stock market as no evidence is found that investors are rewarded for taking increased risk.


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