The Efficiency of Emerging Stock Markets: Empirical Evidence from the South Asian Region

By Cooray, Arusha; Wickremasinghe, Guneratne | The Journal of Developing Areas, Fall 2007 | Go to article overview

The Efficiency of Emerging Stock Markets: Empirical Evidence from the South Asian Region


Cooray, Arusha, Wickremasinghe, Guneratne, The Journal of Developing Areas


ABSTRACT

This paper examines the efficiency in the stock markets of India, Sri Lanka, Pakistan and Bangladesh. The Augmented Dickey Fuller (ADF-1979, 1981), the Phillips-Perron (PP-1988), the Dicky-Fuller Generalized Least Square (DF-GLS-1996) and Elliot-Rothenberg-Stock (ERS - 1996) tests are used to examine weak form stock market efficiency. Weak form efficiency is supported by the classical unit root tests. However, it is not strongly supported for Bangladesh under the DF-GLS and ERS tests. Cointegration and Granger causality tests are used to examine semi-strong form efficiency. Semi-strong form efficiency is not supported as these tests indicate a high degree of interdependence among the South Asian stock markets. The above results have implications for domestic as well as foreign investors in South Asian stock markets.

JEL Classifications: F150, F210, G140, G150

Keywords: South Asia, India, Sri Lanka, Pakistan, Bangladesh, unit root tests, stock markets, market efficiency, impulse response analysis

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

The purpose of this study is to examine the efficiency of the post-deregulation stock markets of South Asia. Stock market efficiency has important implications for investors and regulatory authorities. In such a market, the role of the regulatory authorities is limited as stocks are accurately priced. The efficient dissemination of information ensures that capital is allocated to projects that yield the highest expected return with necessary adjustment for risk. With an efficient pricing mechanism, an economy's savings and investment are allocated efficiently. Hence, an efficient stock market provides no opportunities to engage in profitable trading activities on a continuous basis. If on the other hand, a market is not efficient, the regulatory authorities can take necessary steps to ensure that stocks are correctly priced leading to stock market efficiency.

Research with regard to international financial markets has developed along four lines. The first relates to the integration of markets as opposed to segmented markets - Agmon (1972). The second strand deals with asset pricing models - Solnik (1973), Grauer et al. (1973); the third examines shareholder participation in international diversification - Brewer (1981) and fourth are studies based on the efficient market hypothesis (EMH -Fama (1970)). While the Brewer study is carried out at a micro level on multinational companies and US national companies, a number of studies on the stock market have been carried out at the macro level in relation to the EMH as defined by Fama(1970). Many of these studies are applied studies that use Vector Autoregression, Cointegration and Error correction methodology in order to test for market efficiency. These include the work of Phylaktis and Ravazzolo (2005), Chen, Firth and Meng (2002), Solocha and Saidi (1995), Masih and Masih (2004, 1999) among many others. This study examines weak1 and semi-strong2 forms of the EMH as defined by Fama for the stock markets of Sri Lanka, India, Pakistan and Bangladesh.

Studies of stock price behaviour for the developing economies can be found in Magnusson and Wydick (2002), Chiang et al. (2000) and Alam et al. (1999), Narayan et al. (2004). The results of these studies have been mixed. Magnusson and Wydick (2000) test the random walk hypothesis for a group of African countries and find that there is greater support for the African stock markets than for other emerging stock markets. Chian et al. (2000) analyzing stock returns for a group of Asian economies find that most markets exhibit an autoregressive process rejecting weak form efficiency. Alam et al. (1999) test the random walk hypothesis for Bangladesh, Hong Kong, Sri Lanka and Taiwan. They find that all the stock indices except the Sri Lankan stock index follow a random walk. Narayan et al. (2004) examine the linkages between the stock markets of Bangladesh, India, Pakistan and Sri Lanka using a Granger causality approach among the stock price indices within a multivariate cointegration framework. …

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