EFFICIENT MARKET HYPOTHESIS OF INDIAN EQUITY MARKET

ABSTRACT

Efficient Market Hypothesis (EMH) is an important concept in portfolio investment and diversification. This concept is gaining significance because of integration of international markets helping in movement of investment across national boundaries. This paper tries to test the weak form efficiency for one of the major equity markets in India-Bombay Stock Exchange for the period April 1999 to March 2010. The evidence suggests that the series do not follow random walk thus rejecting the weak form efficiency hypothesis

1. INTRODUCTION

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. In an efficient market, prices of the assets will reflect markets best estimate for the risk and expected return of the asset. Therefore, there will be no undervalued or overvalued assets (Fama 1970). In an efficient market an optimal investment strategy will be to concentrate on risk and return characteristics of the assets. However if the markets are inefficient it is better for investors to research for miss-priced assets which will enhance the overall performance of the portfolio.

Emerging markets have received huge inflows of capital in the recent past and have become viable alternative for investors seeking international diversification. Among the emerging markets India has received its fair share of foreign investment inflows since its reform process began in 1991. The objective of this study is to test whether the Indian equity markets are weak form efficient or not. (Gupta and Basu 2007)

The next section of this paper provides a brief literature review of studies testing market efficiency and a background of the Indian equity market. Section 3 explains the hypothesis to be tested in the paper. Data and research methodology are given in Section 4. Section 5 explains the results and analysis. The last section summarizes the conclusions.

2. LITERATURE REVIEW

Fame (1991) classifies market efficiency into three forms - weak, semi-strong and strong. 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. The strong form efficiency suggests that security prices reflect all available information, even private information. (Fama 1991)

Wheeler, Kowalski and Letza (2002) tried to analyse the efficiency of the Warsaw Stock Exchange (WSE). WSE began with inefficient pricing behaviour when sessions

were limited to one or two days weekly. The period of three sessions of trading each week coincided with dramatic changes in the countrys economic climate. Prices did not respond efficiently and immediately to available information during this period and investors could have secured predictable returns from the individual securities. Later, the number of sessions increased to four and then five days each week and the general level of inefficiency was lower. (Wheeler, Kowalski and Letza (2002)

Aga and Kocaman (2008) tested the weak form of efficiency in the Istanbul Stock Exchange (ISE). The result obtained from the time series analysis shows that it is not possible to earn extraordinarily high returns in an efficient market by using the time series of the past performance to realize a pattern of price changes and to predict stocks future rate of return. (Aga and Kocaman (2008)

Poshakwale (1996) showed that Indian stock market was weak form inefficient. He used daily BSE index data for the period 1987 to 1994. Moving from its traditional functioning to that required by the opening of the capital markets, the BSE has presented different patterns of stock returns patterns of stock returns and supports the validity of day of the week effect. The frequency distribution of the prices in BSE does not follow a normal or uniform distribution which is also confirmed by the nonparametric KS Test. The results of runs test and serial correlation coefficients tests indicate non-random nature of the series and, therefore, violation of weak form efficiency in the BSE. The implication of rejection of weak form efficiency for investors is that they cannot adopt a fair return for risk strategy, by holding a well diversified portfolio while investing in the Indian stock market. (Poshakwale 1996)

Awad and Daraghma (2009) examine efficiency hypothesis in Palestine security exchange (PSE) for 35 stocks included in the PSE market indices. The returns of the 35 sample stocks do not follow the normal distribution, so the study utilizes parametric and nonparametric tests to check for randomness. Daily returns from January, 01, 1998 to October, 30, 2008 were examined for random walks using serial correlation coefficient and runs tests, Augmented Dickey-Fuller, and Phillips-Perron unit root tests (Ibrahim and Zahran 2009). The serial correlation tests indicate that the PSE is inefficient at the weak-level. The unit root tests also suggest the weak-form inefficiency in return series.

BACKGROUND OF EQUITY TRADING IN INDIA

Native brokers from different parts of the country formed the Native Share and Stock Brokers Association in Bombay with a membership fee of Re. 1. The association started with 318 members in July 1875. The Bombay Securities Contract Control Act (BSCCA) came into force in 1925. Bombay Stock Exchange (BSE) became the first exchange in India to get permanent recognition in 1957. On January 2, 1986 the BSE SENSEX was launched as the first stock market index with 1978-79 as the base year. Securities Exchange Board of India (SEBI) was set up in 1992. From September 1992, Foreign Institutional Investors (FIIs) were permitted to invest in the Indian securities market. Trading became screen based for the first time in India since November 1994. SEBI recognized the Interconnected Stock Exchange founded by 15 regional stock exchanges in November 1998. This exchange started functioning in February 1999. (Pathak V) This paper examines the weak form of efficiency in the Indian equity markets using the stock returns of the BSE. BSE is the oldest stock

exchange in Asia. Today, BSE is the world's number 1 exchange in terms of the number of listed companies and the world's 5th in transaction numbers. The market capitalization as on December 31, 2007 stood at USD 1.79 trillion.

3. HYPOTHESIS

The purpose of this study is to examine the efficiency of the BSE at the weak-level. The null and alternative hypothesis:

H0: The stock returns in BSE are random over the time period of the study. H1: The stock returns in BSE are not random over the time period of the study.

4. DATA AND RESEARCH METHODOLOGY

Under the random walk hypothesis, a market is (weak form) efficient if most recent price has all available information and thus, the best forecaster of future price is the most recent price. In the most stringent version of the efficient market hypothesis, t is random and stationary. This study has used returns and not prices for test of market efficiency as expected returns are more commonly used in asset pricing literature (Fama (1998).

The data used in this study is consisted of monthly SENSEX returns for the BSE from 1st of April, 1999 to 31st of March, 2010. Mathematically, the natural logarithm of the relative price was computed for the daily returns to produce a time series of

continuously compounded returns, such that Rt= Log (Pt/Pt-1)*100 where Pt and Pt-1 represent the stock index price at time t and t-1. This paper uses the Augmented Dickey Fuller test (ADF test) and Phillips-Perron (PP test) to examine the aforesaid hypothesis. Three regression models (standard model, with drift and with drift and trend) are used in this study to test for unit root in the research, (Chan, Gupta and Pan 1997). The regression equations are given below.

St = St-1 + t St = u* + *St-1 + *t St = u** +(t-T) + **St-1 + **t Where: St = the stock price u* and u** = the drift terms T = total number of observations t, t*, t** = error terms

(1) (2) (3)

Where St is the logarithm of the price index seen at time t, u is an arbitrary drift parameter, is the change in the index and t is a random disturbance term. Equation (1) is for the standard model; (2) for the standard model with a drift and (3) for the standard model with drift and trend. (Brooks II)

5. RESULTS AND ANALYSIS

Table 1 shows the summary statistics of the data. The mean of the observation is 1.174944. The deviation is 7.989661. The kurtosis is 0.546218 and the skewness is -0.32505. The maximum value is 25.69788 and the minimum value is -24.7461.

Mean Standard Deviation Kurtosis Skewness Minimum Maximum Observations

1.174944 7.989661 0.546218 -0.32505 -24.7461 25.69788 132

TABLE 1: DESCRIPTIVE STATISTICS OF BSE RETURNS (1st APRIL, 1999 TO 31st MARCH, 2010)

This study conducts a test of random walk for the BSE market in India, using SENSEX for the Indian markets. It employs unit root tests (ADF and PP tests). The results are shown in Table 2. PARTICULARS ADF Test statistic(12 lags with intercept and no trend) VALUES -10.16630 PARTICULARS ADF critical values (with intercept and no trend) 1% 5% ADF Test statistic(12 lags with intercept and trend) -10.15216 10% ADF critical values (with intercept and no trend) 1% 5% PP unit root test (with intercept and no trend) -10.26658 10% PP critical values (with intercept and no trend) 1% 5% 10% TABLE 2: RESULTS OF ADF AND PP TEST -3.480818 -2.883579 -2.578601 -4.029595 -3.444487 -3.146073 -3.480818 -2.883579 -2.578601 VALUES

The null hypothesis that the time series is non-stationary is rejected when test statistic is more negative than the critical value at a given level of significance. The above table clearly shows that in both the forms the ADF test statistic is more negative than the critical values which prove that unit root does not exist. So the study suggests that BSE is not weak form efficient. We further test the series using the Phillips-Perron (PP) tests for a confirmatory data analysis. For BSE the results are statistically significant and the results of all the two tests are consistent suggesting these markets are not weak form efficient.

Results of the study suggest that the markets are not weak form efficient. Traditionally Durbin Watson test was used to test the hypothesis. But DW only looks at the serial correlations on one lags as such may not be appropriate test for the daily data. Current literature in the area of market efficiency uses unit root and test of stationarity. This notion of market efficiency has an important bearing for the fund managers and investment bankers and more specifically the investors who are seeking to diversify their portfolios internationally. One of the criticisms of the supporters of the international diversification into emerging markets is that the emerging markets are not efficient and as such the investor may not be able to achieve the full potential benefits of the international diversification.

6. CONCLUSION AND IMPLICATIONS

This paper examines the weak form efficiency in the Indian stock exchanges which represent the majority of the equity market in India. The weak form of efficiency has been tested in the BSE. Different tests like ADF, PP etc have been used to find similar results. The results of these tests find that BSE is not weak form efficient. These results support the common notion that the equity markets in the emerging economies are not efficient and to some degree can also explain the less optimal allocation of portfolios into these markets. For future research, using a computationally more efficient model like generalized autoregressive conditional heteroskesdasticity (GARCH) could help to clear this.

REFERENCES

1. Gupta and Basu 2007, Gupta Rakesh, Basu Parikshit K, (2007), Weak form efficiency in Indian stock markets, International Business & Economic Research Journal, 57-59 2. Fame 1970, Fama, E. (1970). Efficient Capital Markets: A Review of Theory and Empirical Work, Journal of Finance, 25, 283-306. 3. Wheeler, Kowalski and Letza 2002, Wheeler Fred P, Neale Bill and Letza Steve R (2002), The efficiency of Warsaw Stock Exchange: the first few years 1991-1996 , Volume 2 , 45-17 4. Aga and Kocaman 2008, Aga Mehmet and Kocaman Berna (2008), Efficient Market Hypothesis and Emerging Capital Markets: Empirical Evidence from Istanbul Stock Exchange, International Research Journal of Finance and Economics, 140-144

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5. Fama 1991, Fama, E. (1991). Efficient Capital Markets II, Journal of Finance, 46, 1575-1671. 6. Poshakwale 1996, Poshakwale Sunil (1996), Evidence on Weak Form of Efficiency and the Day of the Week Effect in the Indian Stock Market, Finance India, Volume X, Number 3, 605-610 7. Ibrahim and Zahran 2009, Awad Ibrahim and Daraghma Zahran (2009), Testing the Weak-Form Efficiency of the Palestinian Securities Market, International Research Journal of Finance and Economics, Issue 32, 13-15 8. Fame 1998, Fama, E. (1998). Market Efficiency, Long-Term Returns, and Behavioural Finance, Journal of Financial Economics, 49:3, 283-306. 9. Chan, Gupta and Pan 1997, Chan, K. C., Gupta, B. E., and Pan, M. S. (1997). International Stock Market Efficiency and Integration: A Study of Eighteen Nations, Journal of Business Finance and Accounting, 24 (6). 10. Pathak V, Pathak Bharati V, The Indian Financial System- Markets, Institutions and Services, Second Edition, Dorling Kindersley (India) Pvt. Limited, 102-110 11. Brooks II, Brooks Chris, Introductory Econometrics for Finance, Second Edition, Cambridge University Press, 327-335

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