Testing Weak-Form Efficiency of Emerging Economies: A Critical Review of literature/Kritine Kylancios Ekonomikos Mazo Rinkos Efektyvumo Literaturos Apzvalga

Nurunnabi, Mohammad, Journal of Business Economics and Management

1. Introduction

The concept of EMH came from Fama (1970, 1991) based on the argument of Samuelson (1965) who found that the anticipated price of an asset fluctuate randomly. During the past decades, the efficient market hypothesis (EMH) has been a debatable issue in empirical finance literature because of its significance and implications. The study consists four sections including the introduction. The next section provides an overview of random walk model and its implication on weak-form efficiency test. The section three contains the critical review of literature on weak-form efficiency in developed countries, emerging markets and South Asian perspective. The final section summarizes the conclusions.

"The primary role of the capital market is allocation of ownership of the economy's capital stock. In general terms, the ideal is a market in which prices provide accurate signals for resource allocation: that is, a market in which firms can make production-investment decisions, and investors can choose among the securities that represent ownership of firms' activities under the assumption that security prices at any time "fully reflect" all available information. A market in which prices always "fully reflect" available information is called 'efficient' (Fama 1970: 383)".

Fama (1970) suggested three applicable models of EMH including Fair Game model, the Submartingale model, and the Random Walk model. The EMH can be classified into three forms: weak-form, semi-strong form and strong form (Roberts 1959). Weak-form of efficiency claims that the current share prices reflect all the information that is contained in the historical sequence of prices and technical analysis cannot be used to predict and beat market; Semi Strong-form of efficiency implies that current share prices not only reflect all information content of historical prices but also reflect all the publicly available information; Strong-form of efficiency states that current share prices reflect all information whether it is publicly available or private information (insiders information) (Fama 1970). Later, Malkiel (1992) extended Fama's definition following the two arguments: the security prices would be unaffected by revealing the information and it is impossible to make profit based on the revealed information. Therefore, EMH can be measured by the profits based on the information (Jensen 1978; Campbell et al. 1997; Timmermann, Granger 2004). However, their definitions were based on the information and transaction costs, not involving joint hypothesis (Pesaran 2005).

Nowadays, the concept of EMH in emerging market is becoming more important because of the globalization, free movement of investments across national boundaries and the huge capital inflows from developed economies. Traditionally, the markets of developed economies are more efficient compare to emerging markets (Gupta 2006). The fundamental reason is that the development of capital markets is lower which which results in less regulations and control in the weak markets (Gupta 2006). Among the emerging countries in South Asia, the capital markets of Bangladesh are enormously growing very vastly, however not like India, but in an impressive way (See Table 1).

At this stage, it is useful to assess the level of efficiency in Bangladeshi stock market. However, very few research focus on the Bangladesh and they are dated and inconclusive. The empirical research found that emerging markets are not efficient in semi-strong form or strong form. So, it is justifiable to review the weak-form studies rather than semi-strong form or strong form. Wong and Kwong (1984) suggest that if the evidence fails to support weak-form efficiency, it is unnecessary to test the semi-strong form or strong form efficiency at the stricter levels. There are other reasons which might be affected to test the semi-strong form or strong form efficiency in emerging economies, including the unavailability of sufficient data, structural profile, inadequate regulations, lack of supervision, companies' information circulation before the officially availability of annual reports, dramatic movement of the markets and the rumours of information (Worthington, Higgs 2003).

2. Random walk model

Traditionally, the lower the market efficiency, the greater the predictability of stock price changes. According to Fama (1970), the efficient market exists if the share prices are reflected by all available information. In other words, in an efficient market, price changes must be a response only to new information. As the information arrives randomly in market, the share prices fluctuate unpredictably. In weak-form efficient, the price movements fluctuate and the changes of price are independent. In that case, the investors cannot predict the insights of the future prices based on the past information and cannot earn abnormal returns.

The random walk idea of the asset price was introduced by Bachelier in 1900 (Poshakwale 1996). The random walk model sates that the price changes cannot be predicted from earlier changes, the successive price changes of any stock are independent and the price changes occur without any significant trends. The random walk will be consistent with equity being appropriately priced at an equilibrium level, whereas the absence of a random walk will follow the inappropriate of pricing of capital and risk. This has important implications for the allocation of capital development of overall economy. The random walk model can be stated as follows:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII.] (1)

where [P.sub.t+1] = Price of share at time t+1; n = Expected price change; [P.sub.t] = Price of share at time t; [[epsilon].sub.t+1] = Random error with zero mean and finite variance

Ko and Lee (1991) argued that "if the random walk hypothesis holds, the weak-form of the efficient market hypothesis must hold, but not vice versa. Thus, evidence supporting the random walk model is the evidence of market efficiency. But violation of the random walk model need not be evidence of market inefficiency in the weak-form". Fama (1970) strongly support the random walk model in testing the efficiency and pointed out that this model is more powerful than the fair game model. However, Jensen (1978) found that anomalous price behaviour where certain series appeared to follow predictable paths. In later study, Fama (1998) suggests that new behavioural based theories are required because of the apparent anomalies. The most of the previous empirical literature has focused on the random model to test the weak-form efficiency (Groenewold; Kang 1993; Huang 1995; Groenewold, Ariff 1998; Lee et al. 2001; Smith, Ryoo 2002; Fama, French 1988; Osborne 1959; Cootner 1962, 1964; Fama 1965; Fama, Blume 1966; Dimson, Mussavian 1998; Cowles, Jones 1937; Poterba, Summers 1988; Fama et al. 1969, 1993; Fama 1995; Groenewold et al. 1993). Hence, the present study signifies the prior literature on examining the random walk behaviour to test weak-form efficiency in emerging stock market.

On the contrary, the economic theory suggests a number of sources of nonlinearity in the financial data. One of the most frequently citied reasons of nonlinear adjustment is presence of market frictions and transaction costs. Existence of bid-ask spread, short selling and borrowing constraint and other transaction costs render arbitrage unprofitable for small deviations from the fundamental equilibrium. Subsequent reversion to the equilibrium, therefore, takes place only when the deviations from the equilibrium price are large, and thus arbitrage activities are profitable (He, Modest 1995). Consequently, the dynamic behaviour of returns will differ according to the size of the deviation from equilibrium, irrespective of the sign of disequilibrium, giving rise to asymmetric dynamics for returns of differing size (Dumas 1992, 1994; Kragler, Krugler 1993; Obstfeld, Taylor 1997; Shleifer 2000; Coakley, Fuertes 2001; Taylor 2008). In addition to transaction costs and market frictions, interaction of heterogeneous agents (Hong, Stein 1999; Shleifer 2000), diversity in agents' beliefs (Brock, LeBaron 1996; Brock, Hommes 1998) also may lead to persistent deviations from the fundamental equilibrium. On the other hand, heterogeneity in investors' objectives arising from varying investment horizons and risk profiles (Peters 1994), herd behaviour or momentum trading (Lux 1995) may give rise to different dynamics according to the state of the market, i.e., whether the market is rising or falling.

3. Critical review of literature

There are two schools of thoughts on the market efficiency. The first one argues that the markets are efficient and the future returns are unpredictable (Fama 1970). On the other hand, the second ones argue that the EMH theory is contradictory because of the empirical evidence of 'anomalies' (Summers 1986; Keim 1988; Fama, French 198; Lo, MacKinlay 1988; Poterba, Summers 1988). The weak-form efficient market hypothesis states that the current returns are considered to contain all information that is incorporated in historic data and the future returns cannot be forecasted from past returns data. Fama (1991) has extended the predictability power of past returns including the seasonal in returns and the predicting ability of variables (dividends, firm size and interest rates). Following by Fama's theory, there were enormous studies conducted on the weak-form test. The summary of selected studies on developed markets, emerging markets and south Asian markets are given in Table 2. The prior researches are discussed on the arguments surrounding three categories to simplify the research objectives:

3.1. Empirical evidence of developed markets

The earlier study on the weak-form efficiency mostly focused on the developed markets (Working 1934; Kendall 1943, 1953; Cootner 1962; Osborne 1962). Kendall (1953) examined the 19 indices of British industrial share prices and commodity prices in New York and Chicago. Based on the zero serial correlation, the study supports the random walk model. Kendall's findings were supported by the previous study of Working (1934). However, the studies did not provide the economic rationale for the hypothesis because their justifications were based on small sample (Working 1934; Kendall …

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Publication information: Article title: Testing Weak-Form Efficiency of Emerging Economies: A Critical Review of literature/Kritine Kylancios Ekonomikos Mazo Rinkos Efektyvumo Literaturos Apzvalga. Contributors: Nurunnabi, Mohammad - Author. Journal title: Journal of Business Economics and Management. Volume: 13. Issue: 1 Publication date: February 2012. Page number: 167. © 2009 Vilnius Gediminas Technical University. COPYRIGHT 2012 Gale Group.

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