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Article Excerpt
Abstract. This paper exhibits tests of the random walk hypothesis and market efficiency for seven Asian emerging markets as a result of the influence of financial market integration. Random walk properties of equity prices influence the return dynamic and determine the trade strategies of investors. To examine the stochastic properties of local index returns and to test the hypothesis that stock market prices follow a random walk, the single variance ratio tests of Lo and MacKinlay, as well as the multiple variance ratio test of Chow and Denning are employed. The multiple statistical comparison of variance ratios is based on the Studentized Maximum Modulus distribution with control of the joint-test's size. The weak-form market efficiency is also tested directly, using a nonparametric runs test. These tests are particularly useful for investigating stock prices the returns of which are frequently not distributed normally. Documented evidence shows that, from the perspective of local investors, weekly stock prices in major Asian emerging markets do not follow a random walk in the pre-liberalization period. However, in the post-liberalization period the weak-form efficiency hypothesis is generally adopted at the 5% level except for the smaller stock markets of Indonesia and Thailand. These empirical findings suggest that financial integration affects the return predictability in such a way that domestic investors might not be able to develop trading strategies allowing them to earn abnormal returns.
JEL Classifications Numbers: G12, G14, G15
Key words: Asian emerging markets, market efficiency, multiple variance ratio test, random walk, runs test, weak-form market efficiency
1. Introduction
Understanding the behaviour of stock prices in developed, as well as in less developed markets, is a key topic in the finance literature. Stock markets are supposed to have the ability to attract portfolio investments, to enhance domestic savings, and improve the pricing and availability of capital for domestic investment. The achievement of these requirements depends upon the efficiency of stock markets. Whenever stock markets facilitate the operation of the capital market, they play a decisive role in the pricing of risk, and the pricing and allocation of assets (see Smith et al., 2002, p. 475). On the one hand, emerging stock markets serve as a 'natural hedge' in international portfolios as the low correlation coefficients to developed markets' stock returns improve the risk-return characteristics. On the other hand, it is just as important to understand the asset pricing dynamics in these developing countries, so that investors may choose an optimal portfolio allocation. Hence much analysis of stock markets in emerging markets focuses on the stock price formation process or, equivalently, the properties and determination of equity returns. A widespread test of market efficiency is one to control whether individual securities or market indices follow random walk. If stock prices or market indices show a random walk behaviour, then investors will be unable to earn consistently abnormal returns, because shares are priced at their equilibrium values. In contrast, if stocks do not follow a random mechanism, then the pricing of capital and risk will be disturbed, which again will affect the optimal allocation of capital within an economy. In this case price changes would be predictable and investors could achieve excess returns.
With the exception of Chaudhuri and Wu (2003), none of the numerous studies for developing countries has precisely investigated the impact of financial market liberalization on the weak-form efficiency. Most of the analysis simply ignores structural breaks, in terms of financial integration, or financial crises. This paper focuses on the Asian emerging stock markets of India, Indonesia, Korea, Malaysia, the Philippines, Taiwan and Thailand. In brief, the objectives of the study are; (1) to examine the random walk hypothesis (RWH) for stock prices in these seven Asian emerging markets; (2) to determine whether financial liberalization affects tests of asset price dynamics; (3) to test for basic market efficiency across the selected emerging markets, and to provide a robustness test to see whether short-horizon price changes (i.e., weekly) behave similarly to long-horizon price changes (i.e., monthly).
The remainder of this paper is organized as follows. The next section discusses the three well-known forms of market efficiency of Fama (1970), and reveals the weak-form efficiency in conjunction with the random walk hypothesis. Section 3 deals with the methodology of variance ratio tests and runs test. After describing the data and the dates of financial market integration, the empirical results of the two test procedures are presented and interpreted in Section 4. In the final section the paper ends with a brief summary.
2. Information efficiency and random walk hypothesis
In financial literature, a capital market is called 'efficient', if it is not possible to consistently earn an abnormal return by trading on the basis of available information. Fama (1970) distinguished between three forms of market efficiency, with regard to the relevant information subset: (1) A market is weakly efficient if prices fully reflect all information contained in historical price series. Therefore, if stocks follow a random walk, it is impossible to predict future returns by using information in the pattern of stock prices based on technical analysis. (2) The semi-strong-form of efficient market hypothesis (EMH) expands the relevant information set to all publicly available information that might influence the value of a given company (e.g., annual accounts, announcements of annual earnings, stock splits, etc.). Such an efficiency implies that a fundamental analysis of a firm and the economy in general will not enable investors to earn excess returns. (3) If any investor has monopolistic access to all information relevant for price formation, including private (insider) knowledge, then a market is called strongly efficient. Thus, there is no possibility for market participants to make excess returns.
In its weak form, the EMH proposes that share price changes are unpredictable. A frequently employed test of market efficiency is to examine whether or not a price follows a random walk. Under random walk hypothesis (RWH), the behaviour of stock price changes seems to be produced from a random mechanism. In the simplest version of a random walk model, the actual price equals the previous price plus the realization of a random variable:
[P.sub.t] = [P.sub.t-1] + [[epsilon].sub.t] (1)
where [P.sub.t] is the natural logarithm of a stock price and [[epsilon].sub.t] is a random disturbance term. The et satisfy E [[[epsilon].sub.t]] = and E [[[epsilon].sub.t][[epsilon].sub.t-h]] = 0, h [not equal to] for all t. If the expected price change E [[DELTA][P.sub.t]] = E [[[epsilon].sub.t]] = 0, then the best linear estimator for price Pt is the previous price [P.sub.t-1]. Under the assumption that expected price changes l are constant over t, the random walk model expands to a random walk with drift ([mu] = drift parameter):
[P.sub.t] = [mu] + [P.sub.t-1] + [[epsilon].sub.t] [[epsilon].sub.t] ~ i.i.d.(0, [[sigma].sup.2] (2)
or
[DELTA][P.sub.t] = [mu] + [[epsilon].sub.t]. (3)
The random walk implies uncorrelated residuals and hence uncorrelated returns, [DELTA][P.sub.t]. [[epsilon].sub.t] ~ i.i.d. (0, [[sigma].sup.2]) denotes that the increments et are independently and identically distributed (i.i.d.) with E [[epsilon].sub.t] = and E [[epsilon].sub.t.sup.2] = [[sigma].sub.[epsilon].sup.2]. If the [[epsilon].sub.t]'s are i.i.d. normally distributed random variables and therefore price changes are characterized through a white noise process, then Equation (3) is equivalent to an arithmetic Brownian motion and the increments et follow a normal distribution with [[epsilon].sub.t] ~ N(0, [[sigma].sup.2]).
In general there is no identity between the weak form of market efficiency, and the random walk hypothesis. But, if stock prices are found to follow a random walk process, then equity markets are weak-form efficient (Fama, 1970, p. 395). Consequently, the random walk properties of stock returns are considered to be an outcome of the efficient market hypothesis.
3. Methodology
3.1. VARIANCE RATIO TESTS OF RANDOM WALK
The traditional tests of random walks (test of serial correlation and unit-root tests) are susceptible to errors because of spurious autocorrelation induced by non-synchronous trading which is characteristic of stock markets in developing countries, and the lack of power. To resolve this shortcoming, Lo and MacKinlay (1988) developed tests for random walk based on variance ratio estimators. At the same time, these tests are especially useful for investigations in which stock returns are frequently not normally distributed.
3.1.1. Lo and MacKinlay single variance ratio tests
The variance of the increments in a random walk is linearly time-dependent. Thus, if the natural logarithm of a stock price index Pt follows a pure random walk with drift (see Equation (2)), then the return variance should increase proportional to the observation interval q. Suppose a...
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