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Paraschos Maniatis
Stock market risk and price valuation
347
Department of Business Administration, Athens University of Economics and Business, Athens, Greece and KuwaitMaastricht Business School, Salmiya, Kuwait
Abstract
Purpose – The purpose of this study is twofold: to test the hypothesis that the closing prices of Titan S.A. stock can be approximated by a random walk; and to valuate the risk associated to this stock. The ﬁrst question is equivalent to the efﬁcient market hypothesis (EMH) and, therefore, to the predictability of stock’s closing price. The second question follows the ﬁrst in a natural way, since stock’s predictability and risk are in an inverse relationship.
Design/methodology/approach – The paper investigates the existence of unit roots in the stock and in all stock index, in the lines of DickyFuller modeling. It then investigates the stock’s risk focusing the interest in the behavior of the time series volatility under the hypothesis that they can be described by an autoregressive scheme. Finally, it looks at the relationship between stock returns and market returns in the lines of the market model.
Findings – The study concludes that although the predictability of the stock returns is impossible, the risk associated with the stock can to some extent be statistically rationalised.
Originality/value – The paper’s value lies in looking into the probability that if the EMH is even approximately true, accepting aboveaverage risks is the only way to obtain betterthanaverage returns.
Keywords Stock markets, Financial risk, Stock returns, Greece Paper type Case study
1. Literature review
The efﬁcient market hypothesis, risk and risk measures
The efﬁcient market hypothesis. What the efﬁcient market hypothesis (EMH) is concerned with is under what conditions an investor can earn excess returns in a stock. In every day terms, the EMH is the claim that all information available is already reﬂected in the price of the stock.
This statement in the EMH context is equivalent to the statement that the stock’s closing price P _{t} is a random walk. And since the best forecast for the tomorrow’s price in a
random walk is today’s price ðforecast P _{t}_{þ}_{1} ¼ E½P _{t}_{þ}_{1} =P _{t} ; P _{t}_{2}_{1} ;
...P
_{1} all known ¼ P _{t} Þ,
it results that all past information is useless. The origin of the modern ﬁnance stochastic is Bachelier’s (1990) work who claimed in his thesis “The´ orie de la Speculation”, that the logged closing prices lnP _{t} of a stock constitute a time series in which lnP _{t} lnP _{t}_{2} _{1} (which Bachelier deﬁnes as the share’s returns) are stationary independent increments, normally distributed with zero mean and ﬁnite variance. In the ﬁnance literature, the EMH and the Bachelier’s claims are lumped together and collectively labeled random walk theories (RWT), which come in three different versions:
Managerial Finance Vol. 37 No. 4, 2011 pp. 347361 q Emerald Group Publishing Limited
03074358
DOI 10.1108/03074351111115304
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37,4
(1)
The weak RWT. No technical analysis trading system based on price data alone can ever outperform the market. The weak version of RWT is just Bachelier’s claim that one cannot create information about tomorrow’s prices from looking at what happened in the past.
(2) The semistrong RWT. No trading scheme based on any publicly available
348 information will be able to outperform the market. According to semistrong
RWT, not only is technical analysis useless, fundamentals are too. However, the
semistrong version applies only to publicly available information of the sort one can see in the ﬁnancial releases of the companies or listening to governmental pronouncements. All such publicly available information has already been taken into account in setting the current price of the stock. But perhaps there is still hope for a winning portfolioselection strategy by employing insider sources of information. For this case one has.
(3) The strong RWT. No trading scheme based upon any information sources whatsoever can outperform the market. Thus, the strong version claims that no matter where one gets information, it will prove useless in the longterm in obtaining better than market average increment results.
These ideas come with assumptions, either explicit, like Bachelier’s statistical
properties, or implicit, like the EMH’s inherent assumptions about the pricing mechanisms and rationality on the part of investors. There is, however, something inherently paradoxical about the EMH. On the one hand, the EMH claims that is useless to gather information; it will do no better at all in the development of a trading strategy that will outperform the market. On the other hand, the EMH claims that all available information has already been incorporated into the price of the stock. But how can this happen if no one gathers information? In order for the EMH to be valid, there must be a sufﬁciently large number of traders who do not believe
it. So it can be true if the traders do not think it is true
[...].
Further, if the EMH is even
approximately true, then it should be impossible to make consistently betterthanaverage returns. Yet, the empirical evidence clearly indicates otherwise; stock exchange markets in all over the world exhibit such better results. How can this fact be reconciled with consistently better results? The answer is probably that better results can only be obtained by accepting aboveaverage risks. Risk measured by volatility. If the random walk hypothesis is true, it would appear that one cannot really study stock prices in any empirical sense. After all, the aim of most empirical research is to use explanatory variables to explain the variation in a dependent variable. In the present case, the behavior of stock prices cannot be explained empirically other than to say that their changes are inherently unpredictable. What is then the interest in the investigation of stock price behavior? One answer is that one can try to explain the volatility of stock prices. In particular, to investigate whether volatility changes over time in any particular way. In stock markets, volatility is related to risk. That is, if a stock is highly volatile then its price can increase quite substantially, but it can also decrease substantially. An investor interesting in purchasing such a volatile stock might make large gains if the price rises substantially, but could also make losses if it drops. This argument suggests that volatility is a measure of the riskiness of a stock. However, one has to be careful in equating volatility with risk.
Financial models (e.g. the capital asset, capital pricing model, CAPM or the market model) emphasize that the riskiness of a portfolio of stocks depends not only on the volatility of the individual stocks, but also on the correlation between the stocks in the portfolio: consider a portfolio of two stocks that are both very volatile but are also perfectly negatively correlated with one another. The negative correlation suggests that whenever one stock drops in value, the other one rises. So even though each stock is individually risky (due to the high volatility), the risks cancel each other out, and overall the portfolio is quite safe. While the volatility of stocks is an important aspect in an investment decision, there is another aspect that is also important, namely, how the market risk affects the stock’s risk. This question is approached by the market model. Risk measured by the market model. The rationale behind the market model is to relate the returns of an individual stock to the market risk. The tool for this purpose is to regress the stock’s returns to the market returns as measured by the all stocks index and to analyze the stock variation to a part explained by the regression and to a residual not explained part. Strictly speaking the market model investigates the stock’s returns as a function of the market returns. But in ﬁnance, the returns are inherently connected with risk. Interrogation on returns means interrogation on risk.
Stock market risk and price valuation
349
2. Data, symbols and computation details
In our investigation, we have considered the daily closing prices of the ﬁrm’s common stock for the year 2003. Although, there exists much more recent data, we have for obvious reasons chosen as investigation year the year 2003, which is remote from the present situation of the stock. The stock’s closing prices are paired to the closing prices of all stocks general index for the same dates. The data covers the period 2 January 2003 through 31 December 2003, which deﬁnes a time series with 247 daily observations. We have used the following symbols for all performed analyses:
P _{t}
closing price of Titan stock in day t:
DP t ¼ P t 2 P t21
VP _{t}
stock’s volatility in day t deﬁned as the squared deviation of lnðP _{t} =P _{t}_{2}_{1} Þ from
the mean of the terms lnðP _{t} =P _{t}_{2}_{1} Þ, t ¼ 2; 3;
...
; 247:
RP _{t} ¼
P t 2 P t21 P t21
the stock returns
in
day
t
M _{t}
closing price of all stock index (market index) stock in day t:
DM t ¼ M t 2 M t21
VM _{t}
market’s volatility in day t deﬁned as the squared deviation of lnðM _{t} =M _{t}_{2}_{1} Þ
from the mean of the terms lnðM _{t} =M _{t}_{2}_{1} Þ, t ¼ 2; 3;
...
; 247:
RM _{t} ¼
M t 2 M t21
M
t21
the stock returns
in
day
t:
MF
37,4
For all ﬁgures and calculations, we have used the STATISTICA program. The original data and the calculation details are shown in the appropriate STATISTICA ﬁles, appended to this text. However, for convenience reasons, we have embedded the main results in the text.
3. Statistical analysis
350 The statistical analysis includes investigation of unit roots existence in the time series,
risk valuation applying volatility analysis of the time series and risk valuation on the base of the market model.
3.1 Testing for unit roots in the stock and the market
Figure A1 shows in adjusted scaling the closing prices of the stock and market index. The twotime series exhibit a remote but clear similarity in cycles and a rather opposite trend. The similarity in the cyclical movements implies that both time series follow more or less the same market behavior. This conclusion is supported by the spectral analysis of the time series. Figures A2 and A3 show the results of spectral analysis of the time series, after trend elimination and mean extraction. The periodograms of the stock and market exhibit common cycles of duration approximately 60, 120 and 240 days. Therefore, regardless of the opposite trends the series seem to move in the same variation pattern. However, each series considered individually does not exhibit the form of a stationary time series, since the time mean of the series changes with the time. The most of the econometric studies of the stock (and ﬁnancial in general) time series contain a unit root – i.e. they exhibit behavior of a random walk. The consequences of the existence of unit root are fatal in relation to the possibility of forecast the future values of the stock. In order to give evidence to this anticipation, we check the hypothesis of existence of unit roots in the series considering them as a random walk. The analysis relates to the effective markets hypothesis, since under this hypothesis the closing prices is a random walk and the best prediction for the stock is its last realized value. Therefore, the testing of the hypothesis is reduced to testing whether the time series is a random walk or not. In the following, we test the hypothesis that the time series of the stock and all stock indexes are random walks (with or without drift). For this purpose, we apply the DickeyFuller unit root test. According to the formulation of the unit root tests, the models to be tested are:
DP _{t} ¼ 
d þ bP _{t}_{2}_{1} þ 1 _{t} 
ð1Þ 

and: 

DM _{t} ¼ d þ bM _{t}_{2}_{1} þ 1 _{t} 
ð2Þ 
The term 1 _{t} in the models is a random variable (residuals) with zero mean and constant variance. The regressions results are shown in Tables I and II. Testing the values of the b estimates in the above regressions according to the testing scheme H _{0} : b ¼ 0 against the alternative H _{1} : b , 0 at level of signiﬁcance 5 percent, the unit root hypothesis cannot be discarded t ¼ 2 2.84690 . 2 3.14 in model (1) and in model (2) t ¼ 2 0.135337 . 2 3.14. Hence, the time series P and M can be regarded as random walks and there is no better forecast for their closing values than their last realized values. Nevertheless, one can still have some information on the risk exposure
of the stock, investigating the stock’s volatility, in particular investigating the possibility that the volatility can be described by an autoregressive scheme.
3.2 Volatility of stock and market
Stock market risk and price valuation
Figure A4 shows the volatilities of the closing values of the stock and market. The
shape of the schedules gives some evidence that the courses of these two variables are related. Indeed, this anticipation is enforced by the regression of the stock’s volatility VP to markets volatility VM, as obtained by the model:
351
VP _{t} ¼ a þ bVM _{t} þ 1 _{t}
ð3Þ
Table III shows the regression results. As shown in Table III, the relationship of the two variables is poor (adjusted R ^{2} ¼ 10 percent) but the regression’s parameters are signiﬁcantly different to zero ( plevel ¼ 0 for intercept and slope). Hence, the stock’s volatility follows in a remote way the behavior of the markets’ volatility. However, since the scope of the study is the investigation is the stock’s predictability, it is necessary to check the stock’s (and the market’s) predictability by investigating the behavior of each variable considered as a univariate variable. For this purpose, we consider each variable as an autoregressive scheme. Figures A5A7 show the autocorrelation and the partial autocorrelation functions for the stock’s volatility. The shape of the autocorrelation function advocates for the anticipation that the stocks volatility is a white noise. However, estimating the autoregressive scheme:
VP _{t} ¼ a þ bVP _{t}_{2}_{1} 
ð4Þ 

Standard 

Parameter 
error of 
DickeyFuller critical value for 

Parameter 
estimate 
parameter 
t (244) 
plevel 
Adj. R ^{2} 
lefthand ttest at 5 percent 
Table I. 

d 
0.876131 
0.311221 
2.81514 
0.005274 
0.02818 
2 3.14 (for 246 observ.) 
Regression results for unit root test in the model 

b 
2 0.0533309 
0.018725 
2 2.84690 
0.004791 
DP _{t} ¼ d þ bP _{t}_{2}_{1} þ 1 _{t} 

Standard 

Parameter 
error of 
DickeyFuller critical value for 

Parameter 
estimate 
parameter 
t (244) 
plevel 
Adj. R ^{2} 
lefthand ttest at 5 percent 
Table II. 

d 
3.537515 
11.61601 
0.304538 
0.760978 
0.00000 
2 3.14 (for 246 observ.) 
Regression results for unit root test in the model 

b 
2 0.000815 
0.00602 
2 0.135337 
0.892457 
DM _{t} ¼ d þ bM _{t}_{2}_{1} þ 1 _{t} 

Parameter 
Parameter estimate 
Standard error of parameter 
t (244) 
plevel 
Adj. R ^{2} 
Table III. 

a 
0.000153 
0.000026 
5.851587 
0.000000 
0.09944216 
Regression results in the model 

b 
0.497922 
0.094008 
5.296565 
0.000000 
VP _{t} ¼ a þ bVM _{t} þ 1 _{t} 
MF
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352
Positive and signiﬁcant values for the model parameters are obtained. The parameters’ estimation is shown in Table IV. Based on the plevel values for the model parameters, we cannot reject the hypothesis that the stock’s volatility is an AR(1) scheme. Therefore, the stock’s volatility is in some degree, within a conﬁdence interval, predictable. For comparison reasons, we give in Table V the estimation results for the autoregressive scheme:
VM _{t} ¼ a þ bVM _{t}_{2}_{1} þ 1 _{t} :
ð5Þ
In this model, the behavior of the market’s volatility as a white noise cannot be rejected, since the beta’s estimate is not signiﬁcant at a 5 percent signiﬁcance level (the estimation results are shown in Table V). It is likely that the speciﬁc cyclical character of the company’s activity renders offers to the stock’s volatility a degree of predictability, which is not enjoyed by the market’s volatility.
3.3 The market model
In this paragraph, we investigate the risk valuation based on the market model.
The market model is deﬁned as:
RP _{t} ¼ a þ bRM _{t} þ 1 _{t}
a
b
RP _{t} ¼ ðP _{t} 2 P _{t}_{2}_{1} Þ=P _{t}_{2}_{1} RM _{t} ¼ ðM _{t} 2 M _{t}_{2}_{1} Þ=M _{t}_{2}_{1}
1 _{t}
¼ intercept. ¼ slope (the beta coefﬁcient in ﬁnancial vocabulary). ¼ the returns of the individual stock in time t. ¼ the returns of the market (all stocks index) in time t. ¼ regression’s residual error in time t.
In most of times b, the estimate of b, is interpreted as the measure of risk associated to the stock in the sense that if b , 1 the stock is less responding to the market variations and more responding if b . 1. However, a better risk measure is the variance explained by the regression: if (S _{R}_{P} ) ^{2} is the total variance of the depended variable RS can be analyzed as:
ðS _{R}_{P} Þ ^{2} ¼ b ^{2} ðS _{R}_{M} Þ ^{2} þ ðSeÞ ^{2}
Table IV. Parameters estimates in the autoregressive model VP _{t} ¼ a þ bVP _{t}_{2}_{1} þ 1 _{t}
Parameter
Parameter
estimate
Asympt.
standard error
Asympt.
t (244)
plevel
Lower 95 percent conf.
Upper
95 percent conf.
a
b
0.000225
0.134196
0.000027
0.063570
8.333619
2.110991
0.000000
0.035791
0.000171
0.008980
0.000278
0.259412
Table V. Parameters estimates in the autoregressive model VM _{t} ¼ a þ bVM _{t}_{2}_{1} þ 1 _{t}
Parameter
Parameter
estimate
Asympt.
standard error
Asympt.
t (244)
plevel
Lower 95 percent conf.
Upper
95 percent conf.
a
b
0.000145
2 0.029237
0.000015
0.064161
9.805888
2 0.455674
0.000000
0.649030
0.000116
2 0.155618
0.000174
0.097144
In this context, the variance b ^{2} (S _{R}_{M} ) ^{2} , explained by the regression, is considered to be the systematic risk of the stock, associated to the market variations, while the term (Se) ^{2} , the not explained part of variance by the regression, is considered as the speciﬁc risk of the stock due to its individual character. We see that b is involved again in the stock risk but it plays a different role as parameter in the risk measurement. The ratio b ^{2} ðS _{R}_{M} Þ ^{2} =ðS _{R}_{P} Þ ^{2} , which is the squared regression’s coefﬁcient of determination, measures the portion of the stock’s systematic risk in the total stock’s risk. In Table VI, we read a plevel value . 0.05 for the regression’s intercept and a zero plevel value for the beta coefﬁcient. From these values, we conclude that the intercept is not statistically signiﬁcant, while the statistical signiﬁcance of the beta coefﬁcient cannot be rejected at signiﬁcance level 5 percent. Further, the value of beta’s estimate (0.676685), although less than one, indicates sufﬁcient response of the stock’s returns to the market ones. In this aspect, the risk associated to the stock, according to the ﬁnancial interpretation of beta, is less than the market risk. However, much better interpretable is the systematic stock’s risk as measured by R ^{2} , which counts for 29.4 percent of the total stock’s risk, and the speciﬁc risk 100 2 29.4 ¼ 70.6 percent. The two measures are not contradictory, they do not measure exactly the same thing: beta measures the response of the returns to the market returns; R ^{2} measures the risk which can be attributed to the market risk, while 1 2 R ^{2} measures the risk the connected to the speciﬁc character of the stock. From this point of view, both beta coefﬁcient and R ^{2} measure risk, but different kinds of risk.
Stock market risk and price valuation
353
4. Conclusions
Summarizing the ﬁndings of the analysis, we can proceed to the following conclusions:
^{.}
^{.}
The time series of the Titan stock is exposing the characteristics of a random walk, which discards any hope of forecasting its future closing prices, even in a conﬁdence interval. Differing the time series one will obtain a white noise, which is cannot offer any further information. The same conclusion is valid for the all stocks time series. The above results do conﬁrm the long experience from the stock exchange market: the market is unpredictable. If this was not the case, the speculators could systematically obtain (a few) positive proﬁts. But this outcome has never been conﬁrmed by the stock exchange practice and experience.
The positive value of the beta coefﬁcient in the market model regression shows that the movements of the Titan stock follow the movements of the all stocks index. The practical meaning of this result is that the investor has to anticipate the all stocks index in order to estimate the evolution of his own stocks.
^{.} As indicated by the value of beta coefﬁcient the cyclical character of Titan’s activities does not substantially differentiate its returns from the market returns.
^{.}
The Titan’s stock is exposed to a speciﬁc risk about 70 percent of the global stock’s risk.
Parameter 
Parameter estimate 
Standard error of parameter 
t (244) 
plevel 
R ^{2} 
a 
2 0.001110 
0.000807 
2 1.37584 
0.170134 
0.29410088 
b 
0.676685 
0.066651 
10.15259 
0.000000 
Table VI. Regression results in the model RP _{t} ¼ a þ bVM _{t} þ 1 _{t}
MF
37,4
^{.}
354 ^{.}
Although, the closing prices of the stock do not offer any prediction help, the stock’s volatility can to an extent be foreseen, since its volatility can plausibly be described by an autoregressive scheme AR(1). Besides, regressing the stock’s volatility to market’s volatility, one obtains statistically signiﬁcant estimates of intercept and slope, which can offer additional information for the stock’s volatility.
Given the high degree of risk in the stock, one has to reckon with increased
speculation proﬁts in order to restore the balance higher risk/higher proﬁts.
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(The Appendix follows overleaf.)
MF
37,4
Appendix. STATISTICA ﬁles
356
Figure A1.
Closing prices of stock
and market index
Figure A2.
Spectral analysis of stock
Note: No. of cases: 246
Spectral analysis of market
MF
37,4
358
Figure A5.
Autocorrelation
function VP
Note: Standard errors are whitenoise estimates
Figure A6.
Partial autocorrelation
function VP
Note: Standard errors assume AR order of k–1
0.004
0.003
0.002
0.001
0.000
–0.001
0.004
0.003
0.002
0.001
0.000
–0.001
–20
0
20
40
60
80
100
120
140
160
180
200
220
240
260
280
Notes: Start of origin: 1; end of origin: 246
Stock market
risk and price
valuation
359
Figure A7.
Forecasts; model: (1,0,0) seasonal lag: 12 input VP
Lag
Corr.
1 –0.029
2 +0.030
3 +0.101
4 +0.046
5 +0.176
6 –0.010
7 –0.083
8 +0.176
9 +0.069
10 +0.008
11 +0.007
12 +0.069
13 +0.052
14 +0.043
15 –0.086
S.E.
0.0634
0.0632
0.0631
0.0630
0.0629
0.0627
0.0626
0.0625
0.0623
0.0622
0.0621
0.0619
0.0618
0.0617
0.0615
Q
p
0.21 0.6450
0.44 0.8029
3.00 0.3917
3.54 0.4712
11.40 0.0440
11.43 0.0760
13.20 0.0675
21.17 0.0067
22.41 0.0077
22.43 0.0131
22.44 0.0212
23.70 0.0224
24.42 0.0275
24.90 0.0356
26.84 0.0301
–1.0
–0.5
0.0
0.5
1.0
Note: Standard errors are whitenoise estimates
Figure A8.
Autocorrelation
function VM
MF
37,4
360
Figure A9.
Partial autocorrelation
function VM
Note: Standard errors assume AR order of k–1
Figure A10.
Forecasts; Model: (1,0,0) seasonal lag: 12 input: VM
Notes: Start of origin: 1; end of origin: 246
RP
Note: y = 0.001+ 0.677*x+eps
Corresponding author
RM
Paraschos Maniatis can be contacted at: pman@sch.gr
Figure A12.
Regression of RP to RM
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