Efficient market hypothesis: the case of India's equity market.

Abstract: The study of equity market efficiency has been the objective of many researches across the globe since the last few decades. But the evidence is mixed on whether the equity market is efficient. While some studies conclude that the equity markets are efficient, other studies cast doubt on this conclusion. Equity market efficiency suggests that equity prices incorporate all relevant information when that information is readily available and widely disseminated, which implies that there is no systematic way to exploit trading opportunities and acquire excess profits. This concept is significant for investors who wish to hold internationally diversified portfolios. If equity markets are not efficient, then the task of constructing an internationally diversified portfolio for an investor will become arduous. With the increased movement of investments into emerging markets, greater importance is being given to the understanding of the market efficiency in emerging markets like India. It is with this backdrop, this paper empirically examines the efficient market hypothesis in its weak form for the two major equity markets in India--BSE and NSE for the period 1997 to 2011 and provides the evidence of conflicting results. Keywords: Weak form market efficiency, Random walk hypothesis, Equity Market, BSE, NSE. JEL Classification Code: C22, E44, G14. Article Type: Report Subject: Stock markets Industrial efficiency Investments Investment analysis Author: Mishra, P.K. Pub Date: 04/01/2012 Publication: Name: Abhigyan Publisher: Foundation for Organisational Research & Education Audience: Academic Format: Maga zine/JournalSubject: Business; Social sciences Copyright: COPYRIGHT 2012 Foundation for Organisational Resear ch & Education ISSN: 0970-2385 Issue: Date: April-June, 2012 Source Volume: 30 Source Issue: 1 Topic: Computer Subject: Stock market Accession Number: 299639636 Full Text: [ILLUSTRATION OMITTED] Introduction In recent years, emerging market nations like India have attracted the attention of the researchers, policy makers, academicians and the investors. Emerging markets have received huge inflows of capital in the recent past and became viable alternative for investors seeking international diversification. And, such international diversification of portfolios calls for the existence of efficient equity markets in the emerging market economies. If equity markets are not efficient, the task of constructing an internationally diversified portfolio for an investor will become arduous. Thus, this paper proceeds to examine the efficiency of India's equity market. The equity market of India has witnessed a radical transformation in the last decade or so owing to the judicious policy measures implemented through the financial sector reforms of 1990s. The adoption of international quality trading and settlement mechanisms and reduction of transactions costs have made the investors, domestic and foreign, more optimistic which in turn evidenced a considerable growth in market volume and liquidity. The market features a developed regulatory framework, a modern market infrastructure, removal of barriers to the international equity investment, better allocation and mobilization of resources and increased transparency.

The term 'market efficiency' is used to explain the relationship between information and security prices in the capital market literature. It examines the degree, the pace, and the accuracy of the available information being incorporated into security prices. An efficient stock market is commonly thought of as market in which security prices fully reflect all relevant information that is available about the true value of the securities. Reilly and Brown (1997) define an efficient market as one in which stock prices adjust rapidly when new information arrives and, therefore, the current prices of stocks have already reflected all information about the stock. Thus, the market leaves no pattern to exploit the trading opportunities and to make excess economic gains. The concept of EMH is based on the arguments put forward by Samuelson (1965) that anticipated price of an asset fluctuate randomly around its expected value. Fama (1970) states that there exist three different degrees of market efficiency based on what is meant as 'available information'--the weak, semi-strong, and strong forms. Weak form efficiency exists when security prices reflect all the information contained in the history of past prices and returns. If stock markets are weak-form efficient, then investors can not earn super-normal profits (excess profits) from trading strategies based on past prices or returns. Therefore, stock returns are not predictable, and hence follow a random walk. Under semi-strong form efficiency, security prices reflect all publicly available information. Investors, who base all their decisions on the information that becomes public, cannot gain above average returns. Under strong form efficiency, all information even apparent company secrets--is incorporated in security prices and thus, no investor can earn excess profit by trading on public or nonpublic information. It was the strong belief of the traditional financial analysts that stock markets are efficient because stock prices reflect the true market value of future dividends. In recent years, however, many market analysts have started arguing for market inefficiency, at least in its weak form. They claim that the traders are now paying more attention to information related to recent trends in returns instead of putting emphasis on the information related to future dividends. Quite a good number of traders are buying the stocks only because past returns were high. These traders, often called feedback traders, believe that if stock returns have been high in the recent past, they are likely to be high in the future. Such behavior causes stock prices to go beyond the true values of stocks in the short run. Similarly, the feedback traders are selling the stocks when the stock returns have been low in the recent past. Large selling drives the stock prices to fall below the true values. This feedback trading makes the market more volatile in the short run because in the long run the stock prices tend to return to their true values. This is called mean reversion. Equity market efficiency has important implications for the investment policy of investors because if the equity market in which they are investing is efficient, researching to find underpriced or overpriced assets will be a futile exercise. 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 the available information at the time. Therefore, there will be no undervalued assets with an expectation of higher than expected risk adjusted return or overvalued assets offering lower than the expected return. All assets will be fairly priced in the market offering optimal reward to risk. In an efficient market an optimal investment decision will be to look at risk and return characteristics of the asset and/or portfolio. On the contrary, if the markets were not efficient, an investor will be better off trying to identify miss-priced assets as correct identification of such assets can enhance the overall performance of the portfolio Rutterford (1993). EMH has two important functions--as a theoretical and predictive model about how financial markets operate; and as a tool in an impression management campaign to influence more people to invest their savings in the stock market (Will, 2006). At present, India has become the fastest growing emerging market economies in the world. The strong fundamentals of Indian economy have increased the demand for investment funds significantly, and thus, the capital market growth is expected to play an increasingly important role in the process. At this juncture, it is quite imperative to assess the level of efficiency of the equity market in India. It is with this backdrop, this paper is an attempt to investigate the level of market efficiency of India's equity market for the period 1997 to 2011. The rest of the paper is organized as follows: Section II reviews the literature; Section III discusses the data and methodology; Section IV makes the analysis; and Section V concludes. Literature Review The efficiency of stock markets is one of the most controversial and well studied propositions in the literature of capital market. Even if there have been a number of researches and journal articles, economists have not yet

reached a consensus about whether capital markets are efficient or not. The wide range of studies concerning the efficient market hypothesis in the literature provides mixed evidences. The efficient market hypothesis keeps a relation with the random walk theory. The idea that asset prices may follow a random walk pattern was introduced by Bachelier in 1900 in the dissertation submitted by him to the Sorbonne for his Ph.D in mathematics (Dimson and Mussavian, 1998). The random walk hypothesis is used to explain the successive price changes which are independent of each other. In other words, tomorrow's price change (and, therefore, tomorrow's price) cannot be predicted by looking at today's price change, i.e. [P.sub.t-1]- [P.sub.t] is independent of [P.sub.t-], [P.sub.t-1]. This implies that historical returns are not useful for predicting future returns, which is consistent with weak-form market efficiency. Studies on market efficiency of equity markets in India are only a few in the finance literature. The studies such as Sharma and Kennedy (1977), Barua (1980, 1987), Sharma (1983), Ramachandran (1985), Gupta (1985), Srinivasan (1988), Vaidyanathan and Gali (1994) and Prusty (2007) supports the weak form efficiency of Indian capital market. There have been some studies like Kulkarni (1978), Chaudhury (1991), Poshakwale (1996), Pant and Bishnoi (2002), Pandey (2003), Gupta and Basu (2007), Mishra, (2009), Mishra and pradhan (2009), Mishra (2010), Mishra et al (2011), and Mishra (2011) do not support the existence of weak form efficiency in Indian capital market. This disagreement regarding the Efficient Market Hypothesis has generated research interest in this topic. Data and Methodology The very objective of this study is to determine market efficiency of equity market in India. For this purpose, we considered two stock exchanges--BSE and NSE. The BSE has the largest number of listed companies in the world and the equity market capitalization of the companies listed on the BSE was US$1.63 trillion as of December 2010, making it the 4th largest stock exchange in Asia and the 8th largest in the world. The 9th largest stock exchange in the world by market capitalization is NSE, the other stock exchange located at Mumbai, India. It has the market capitalization of around US$1.59 trillion and over 1,552 listings as of December 2010. BSE is the oldest stock exchange in India and as such has the longest time series data available. Stability in prices for the BSE was considered to be an important feature. During the period 1987 to 1994, average annual price fluctuations of ordinary shares on BSE were 25.1 percent as compared with London Stock Exchange (22 percent), and the New York Stock Exchange (23.9 percent) (Poshakwale, 1996). NSE is one of the newer stock exchanges in India. Because of government's support, NSE is becoming more accessible market to domestic and foreign investors. Currently NSE is the largest stock exchange in India by daily turnover and number of trades for both equities and derivative trading. The perceived liquidity and accessibility of the NSE market is an important factor and may have different impact on the market efficiency. High liquidity in the market is an important pre-condition for the market efficiency, since a thinly traded market is not in a position to adjust to the new information quickly and accurately. Thus, analysis of two major equity markets in India together should provide a more comprehensive and complete picture. In this study we have used returns and not prices for test of market efficiency as expected returns are more commonly used in asset pricing literature (Fama, 1998). In order to test market efficiency one can look at the pattern of short-term movements of the combined market returns and attempt to identify the underlying process generating those returns. If the market is efficient, the model would fail to identify any pattern and it can be inferred that the returns follow a random walk process. In essence the inference of random walk means that either the returns follow a random walk process or that the model used to identify the process is unable to identify the true return generating process. If a model is able to identify a pattern, then historical market data can be used to forecast future market prices, and the market is regarded as not efficient. There are several techniques available to determine patterns in time series data. Regression, exponential smoothing and decomposition approaches presume that the values of the time series being predicted are statistically independent from one period to the next. Some of these techniques are reviewed in the following section and appropriate techniques identified for use in this study. Runs (Bradley, 1968) and LOMAC variance ratio tests (Lo and MacKinlay, 1988) are used to test the weak form

efficiency and random walk hypothesis. Runs test determines if successive price changes are independent. It is nonparametric and does not require the returns to be normally distributed. The test observes the sequence of successive price changes with the same sign. The null hypothesis of randomness is determined by the same sign in price changes. The runs test only looks at the number of positive or negative changes and ignores the amount of change from mean. This is one of the major weaknesses of the test. LOMAC variance ratio test is commonly criticised on many issues and mainly on the selection of maximum order of serial correlation (Faust, 1992). Durbin-Watson test (Durbin and Watson, 1951), the augmented Dickey-Fuller test (Dickey and Fuller, 1979) and different variants of these are the most commonly used tests for the random walk hypothesis in recent years (Worthington and Higgs, 2003; Kleiman, Payne and Sahu, 2002; Chan, Gup and Pan, 1997). A simple formal statistical test was introduced was Durbin and Watson (1951). Durbin-Watson (DW) is a test for first order autocorrelation. It only tests for the relationship between an error and its immediately preceding value. One way to motivate this test is to regress the error of time with its previous value. [u.sub.1] = [rho][u.sub.t-1] + [v.sub.1] where [v.sub.1] ~ N(0, [[sigma].sup.2]) (1) DW test cannot detect some forms of residual autocorrelations, e.g. if Corr([u.sub.1],[u.sub.t-1]) = 0 but Corr([u.sub.1],[u.sub.t-2]) [not equal to] 0, DW as defined earlier will not find any autocorrelation. One possible way is to do it for all possible combinations but this is tedious and practically impossible to handle. The second-best alternative is to test for autocorrelation that would allow examination of the relationship between [u.sub.1] and several of its lagged values at the same time. The Breusch-Godfrey test is a more general test for autocorrelation for the lags of up to r'th order. (1) [u.sub.t] = [[rho].sub.1][u.sub.t-1] + [[rho].sub.2][u.sub.t-2] + [[rho].sub.3][u.sub.t-3] + ... + [[rho].sub.r][u.sub.t-r] + [v.sub.t], [v.sub.t] ~ N(0,[[sigma].sup.2.sub.v] (2) Because of the above mentioned weaknesses of the DW test we do not use the DW test in our study. An alternative model which is more commonly used is Augmented Dickey Fuller test (ADF test). 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, Gup and Pan, 1997; Brooks, 2002). In this study we followed the test methodologies from Brooks (2002) with slight adjustments. [P.sub.t] = [alpha][P.sub.t-1] + [[epsilon].sub.t] (3) [P.sub.t] = [u.sup.*] + [[alpha].sup.*][P.sub.t-1] + [[epsilon].sup.*.sub.t] (4) [P.sub.t] = [u.sup.**] + [beta](t - n) + [alpha][P.sub.t-1] + [[epsilon].sup.**.sub.t], (5) Where: Pt = the stock price [u.sup.*] and [u.sup.**] = the drift terms n = total number of observations [[epsilon].sub.t], [[epsilon].sub.t.sup.*], [[epsilon].sub.t.sup.**] = error terms that could be ARMA processes with time dependent variances. Where St is the logarithm of the price index seen at time t, u is an arbitrary drift parameter, [alpha] is the change in the index and [[epsilon].sub.t] is a random disturbance term. Equation (3) is for the standard model; (4) for the standard model with a drift and (5) for the standard model with drift and trend. Augmented Dickey-Fuller (ADF) unit root test of non-stationarity is conducted in the form of the following regression equation. The objective of the test is to test the null hypothesis that [theta] = 1 in: [y.sub.t] = [theta][y.sub.t-1] + [u.sub.t] against the one-sided alternative [theta] < 1. Thus, the hypotheses to be tested are:

[H.sub.0]: series contains a unit root Vs. [H.sub.1]: series is stationary In this study we calculate daily returns, weekly returns, and monthly returns using index values for the Mumbai Stock Exchange (BSE) and National Stock Exchange (NSE) of India. The data is collected from the official websites of both stock exchanges. The time period for both BSE and NSE is from 1997 to 2011. Stock exchanges are closed for trading on weekends and this may seem to violate the basic time series requirement that observations be taken at a regularly spaced intervals. The requirement however, is that the frequency be spaced in terms of the processes underlying the series. Here the underlying process of the series is trading of stocks and generation of stock exchange index based on the stock trading, as such for this study the index values at the end of each business day is appropriate (French, 1980). Empirical Results In order to test the efficiency of India's equity market, we employ unit root tests. We perform ADF test for standard model, with drift and with drift and trend, however the results are presented for the model with drift and with trend only as the results for the other variant are similar and do not impact the conclusions. We also test market efficiency using the Phillips-Perron and the KPSS tests. Using full sample period of 1997 to 2011, the null hypothesis of unit root is convincingly rejected as the test statistic is more negative than the critical value, suggesting that these markets do not show characteristics of random walk and as such are not efficient in the weak form. The results are presented in Table-I. For both BSE and NSE markets, the results are statistically significant and test of serial correlation show the markets exhibiting that the markets are not weak form efficient using the full sample period. All frequencies show similar results using ADF and PP results. However, results of KPSS test show markets are weak form efficient using daily, weekly and monthly data. For further analysis we partitioned the data into different periods. Table-II shows results for the period from 1997 to 2007. Results show that ADF test and PP test for all frequencies show that Indian equity market is not weak form efficient. However, results for KPSS test show that BSE is not weak form efficient, but NSE is weak form efficient for weekly frequency. Table-III shows results for the period 2007 to 2009 and the results show that Indian equity market is weak form efficient for weekly and monthly frequencies, but not for daily frequency. PP test still shows that market is not weak form efficient. KPSS test finds that NSE and BSE are weak form efficient based on weekly and monthly data, but not on the basis of daily data. Finally, for the period 2009 to 2011 period results (Table-IV) are still mixed for a lower frequency data--monthly and quarterly, all tests find markets weak form efficient for Indian equity market. Results for daily and weekly frequencies are also mixed. Conclusion This paper examines the weak form efficiency of the Indian equity market. We employed three different tests ADF, PP and the KPSS tests and found similar results. These tests provide mixed results. Results for later periods are more favorable in terms of weak form efficiency. Thus, 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. Results also support the common belief that markets in the emerging countries may be moving towards being more informationally efficient. Results for the latter period show equity market in India is weak form efficient based on all three tests whereas earlier period show conflicting results. Hence, the investors may not be able enjoy the maximum potential benefits of the international diversification. But, people such as corporate officers who have inside information can do better than the market averages, and individuals and organizations that are especially good at digging out information on small, new companies are likely to consistently do so well. However, the major macro-economic problem for the economy is that investment funds may not be channeled to where they are actually most useful. This resource mal-allocation in the long-run would be destructive as it may hinder the sustainable development of the economy. Referencess

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