Empirical Evidence on Indian Stock Market Efficiency in ...


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Empirical Evidence on Indian Stock Market Efficiency in ...

  1. 1. Global Journal of Finance and Management ISSN 0975 - 6477 Volume 1, Number 2 (2009), pp. 149-157 © Research India Publications http://www.ripublication.com/gjfm.htm Empirical Evidence on Indian Stock Market Efficiency in Context of the Global Financial Crisis 1 P K Mishra, 2K B Das and 3B B Pradhan 1 Sr. Lecturer in Economics, Siksha O Anusandhan University, Bhubaneswar, India Corresponding Author E-mail: pkmishra1974@gmail.com 2 Professor, Dept. of A & A Economics, Utkal University, Bhubaneswar, India E-mail: drkbdas@gmail.com 3 Professor and Registrar, Siksha O Anusandhan University, Bhubaneswar, India E-mail: registrar@soauniversity.ac.in Abstract The study of stock 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 stock market is efficient. While some studies conclude that the stock markets are efficient, other studies cast doubt on this conclusion. Stock market efficiency suggests that stock 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. In other words, stock prices follow a random walk which holds that stock price changes are independent of one another. This paper is an attempt to provide some empirical evidence on the efficiency of Indian stock market in the context of recent global financial crisis. The study by employing the unit root tests on the sample of daily stock returns, presents the evidence of weak form market inefficiency in India. The study further examines the mean reversion implication of market inefficiency and suggests the existence of mean reversion illusion in India. KEY WORDS: Indian Stock Market, Efficient Market Hypothesis, Random Walk, Financial Crisis, Mean Reversion. JEL Classification: C12, C22, C52, G10, G14
  2. 2. 150 P K Mishra, K B Das and B B Pradhan Introduction The stock market of India have witnessed a radical transformation in last the decade or so owing to the judicious policy measures implemented through the financial sector reforms of nineties. 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. All these infer better efficiency of Indian stock market. Despite this transformation, Indian stock market has recently shown greater volatility due to global financial crisis which has affected the informational efficiency of markets. An eventful year of great turbulence has begun in the Indian stock market scenario with a continual fall in stock prices on news that Lehman Brothers, Merrill Lynch, and many other investment bankers and companies collapsed. And, Indian stock market has seen its worst time with the global financial crisis. Mostly all the industrial sectors experienced a consistent low in their stock prices. The Sensex which had reached historically high levels in the beginning of 2008, declined to its levels three years back. Similar trend has also been observed for the S & P CNX Nifty. The movements in Sensex and CNX Nifty between January 2007 and July 2009 are shown in Fig. 1(a) and 1(b). BSE Sensex [Jan 2007 to July 2009] NSE Nifty [Jan 2007 to July 2009] Figure 1(a) Figure 1(b) However, Indian stock market showed remarkable resistance to the winds from the international financial implosion. Now, the stock market of India has returned to its previous growth track in spite of a greater degree of volatility. In this context, it is very much essential to study the efficiency of Indian stock market as the possibility of undervaluation or overvaluation of a sizable amount of stock prices is there.
  3. 3. Empirical Evidence on Indian Stock Market 151 The term ‘market efficiency’ is used to explain the relationship between information and share 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. Fama (1970) defines an efficient market as a market in which prices always reflect the recent available information and states that three different levels of efficiency exist 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 non-public information. It was the strong belief of the traditional 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 behaviour 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. A quick review of the Indian stock market behaviour since 2007 gives an impression that some Indian traders are feedback traders and they show a swarm like entry in the market when stock returns have been high in the recent past; and exit from the market when stock returns have been low in the recent past. Perhaps, this is the reason why Indian stock market indices have witnessed a bull run till January 2008. From the second quarter of 2008, the global contagion became a bear hug in Indian market. Most of the FIIs walk out of the market showing the way to domestic investors. And, the market witnessed its ever noticed bad time. Again recently the
  4. 4. 152 P K Mishra, K B Das and B B Pradhan market has been showing an astonishing rebound. Thus, it seems that the global market recession has influenced the stock market efficiency in India. It is with this backdrop this paper examines the weak form efficiency of Indian stock market in the context of global financial crisis. The organisational structure of the paper is as follows: section II reviews related literature, section III discusses the data and methodology of the study, 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 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) and Gupta and Basu (2007), (Mishra, 2009) and (Mishra & pradhan, 2009) 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. Additionally, the recent market downsizing across the globe has also contributed to it. Furthermore, this paper shall fill the gap in the capital market literature by studying the weak form market efficiency in the aftermath of global financial crisis. Data and Methodology Examining the efficient market hypothesis in its weak form in the context of Indian stock market being the objective, this paper selects two leading stock exchanges of India, viz., Stock Exchange, Mumbai and National Stock Exchange because of their undoubted popularity across the globe so as to represent the Indian stock market. The study uses the daily stock return data computed from daily closing stock prices as ⎛ I ⎞ recorded in terms of Sensex and Nifty. The formula used thereof is Rt = Log ⎜ t ⎟ , ⎝ I t −1 ⎠ where Rt is the daily stock return and I t is the daily closing Sensex at time t. The sample period spans from January 2007 to July 2009. All data are obtained from the RBI database on Indian economy. The study proceeds to test the null hypothesis of stock market inefficiency in India against the alternative of stock market efficiency. In this regard, the study uses the most popular unit root test. First, we performed the Phillips-Perron (PP) test and then the Kwiatkowski, Phillips, Schmidt, and Shin (KPSS) test has been conducted as the confirmatory test of unit root.
  5. 5. Empirical Evidence on Indian Stock Market 153 The PP method estimates the non- augmented DF test equation: ΔRt = α Rt −1 + xt'δ + ε t & α = ρ − 1 Where, Rt is the monthly compounded rate of return calculated on the basis of BSE and NSE monthly stock price indices, xt are optional exogenous regressors which may consist of constant, or a constant and trend, ρ and δ are parameters to be estimated, and, ε t are assumed to be white noise. The null and alternative hypotheses of this test are H 0 : α = 0 and H1 :α < 0 The null hypothesis that the time series is non-stationary is rejected when test statistic is more negative than the critical value at a given level of significance. The KPSS test assumes trend-stationary time Rt under the null hypothesis. The KPSS statistic is based on the residuals from the OLS regression of Rt on the exogenous variables xt : RT = xt'δ + ut The KPSS attempts to test the null hypothesis that series is stationarity against the alternative hypothesis of non-stationarity. And, this null hypothesis is accepted if the test statistic is less than the critical value; otherwise rejected. At last the study regress current stock returns (Rt) on past stock returns (Rt-1) by formulating the regression model of stock returns with a constant term and a term of past returns so as to examine the mean reverting behaviour of stock prices in India. Such a regression model is: Rt = β 0 + β1 Rt −1 + ε t . This model will exhibit mean reversion of stock prices, if the slope coefficient is negative. Empirical Analysis The empirical testing of the efficient market hypothesis in its weak form has been performed by applying the PP and KPSS unit root tests. The results of these tests for the sample period are summarized in Table-1. Table 1: Results Of Unit Root Test. For a Period from Jan 2007 to July 2009 PP Unit Root KPSS Unit Root Test Test Return Series Based on BSE Daily Sensex -23.14 [19] 0.14 [17] 30 Index Return Series Based on NSE Daily Nifty -23.70 [20] 0.13 [17] 50 Index The values within brackets refer to the bandwidth selected on the basis of Newey- West criterion using Bartlett Kernel principle. The test statistics are significant at 1% level of significance, and thus, null hypotheses of unit roots are rejected. It indicates
  6. 6. 154 P K Mishra, K B Das and B B Pradhan that the unit roots do not exist, and the series are stationary. This provides the evidence that the stock markets of India do not show characteristics of random walk and thus, are not efficient in the weak form. Therefore, the opportunities of predicting the future prices thereby earning excess profits exist in Indian stock markets. This opportunity of making excess profits happens to provide incentives to market participants to introduce new financial products to mobilise the savings of potential investors. As soon as these new financial instruments appear in the market, they will generate greater efficiency in the allocation of risks by breaking the links between origination and ownership, and by creating new securities that can more finely allocate risks to different investor classes. These innovations in the financial sector will undoubtedly bring efficiency in the allocation of capital, reduce the cost of capital, and contribute to economic growth. Thus, financial innovations in the emerging financial sectors of India as a whole are beneficial. This does not mean that financial innovations are free of risks and shortcomings. The recent global financial crisis is there to remind us that financial innovations are mixed blessings. Another aspect of stock market inefficiency is mean reversion. Poterba and Summers (1988) concludes that the stock market is inefficient because prices are mean reverting. If stock price follows a mean reverting process, then there exists a tendency for the price level to return to its trend path over time, and investors may be able to forecast future returns by using information on past returns. This tends to make the market inefficient. In a very broad sense, stock market is mean reverting if asset prices tend to fall (rise) after hitting a maximum (minimum). Using this definition, many analysts can convince themselves that stock markets obviously mean revert. For example, (so the thinking goes), the stock market was clearly overvalued in the first quarter of 2008 in India. This overvaluation explains the subsequent falls. In other words, mean reversion explains the stock market crash. One can test this indication of mean reversion by regressing stock returns on past stock returns (Engel and Morris, 1991). Such regression in Indian stock market over the sample period yields: Rt = 0.000089 + 0.074 Rt −1 for Stock Exchange, Mumbai, and Rt = 0.00013 + 0.054 Rt −1 for the National Stock Exchange. Here, the slope coefficient is positive for both the regressions. Thus, the stock prices are not mean reverting. The indication of mean reversion as is evident from the stock price movement in India, is therefore an illusion. Conclusion Since last few decades many researchers and analysts have been trying to examine the efficient market hypothesis in the capital market of developed and emerging nations. Despite their novel attempt, the hypothesis remains a controversial issue. The economists have not yet reached a consensus about whether capital markets are efficient or not. Thus, this paper focused on testing the efficient market hypothesis in its weak form in Indian stock market in the context of global financial crisis. By
  7. 7. Empirical Evidence on Indian Stock Market 155 embarking upon the popular unit root test, the study provides the weak form inefficiency of Indian stock market in the sample period. This market inefficiency has several implications. First, the share prices may not necessarily reflect the true value of stocks. So, companies with low true values may be able to mobilise a lot of capital, while companies with high true values may find it difficult to raise capital. This disrupts the investment scenario of the country as well as the total productivity. Second, market inefficiency may imply mean reversion of prices that may cause expected returns to vary. Third, market inefficiency may imply excess price volatility in the short run because prices change by more than the value of the new information. Last but not the least, weak form market inefficiency may have the positive impact on the process of financial innovation. In a state of market inefficiency, opportunities for supernormal profit exist because the future prices can be predicted following the information contained in past prices. So the expectation for excess profit will stimulate short run investment which may act as the best incentive for introducing sophisticated new financial products to exploit the environment. Looking at the pros of market inefficiency, one should say that it is a national virtue. The major problem for the economy of an inefficient market is that investment funds are not channelled to where they are most useful. This resource mal-allocation in the long run is destructive as it would hinder the sustainable development of the economy. References [1] Barua, S. K. (1981). Short-run Price Behaviour of Securities: Some Evidence from Indian Capital Market. Vikalpa , Vol.6, No.2, pp.93-100. [2] Barua, S. K. (1980). Valuation of Securities and Inflence of Value on Financial Decision of a Firm. Doctoral Dissertation, Indian Institute of Management, Ahmedabad. [3] Barua, S. K., & Raghunathan, V. (1987). Inefficiency and Speculation in the Indian Capital Market. Vikalpa , Vol.12, No.3, 53-58. [4] Belgaumi, M. S. (1995). Efficiency of the Indian Stock Market: An Empirical Study. Vikalpa , Vol.20, No.2, pp.43-47. [5] Bhat, R., & Pandey, I. M. (1987). Efficient Market Hypothesis: Understanding and Acceptance in India. Working Paper No. 691, IIM, Ahmadabad . [6] Chander, R., Mehta, K., & Sharma, R. (2008). Empirical Evidences on Weak Form Stock Market efficiency: The Indian Experience. Decision , Vol.35, No.1, pp.75-109. [7] Chander, S., & Phillip. (2003). Behaviour of Stock Market Prices at BSE and NSE: An application of Runs Test. Journal of Accounting and Finance , Vol.17, No.2, pp.41-57. [8] Choudhury, S. K. (1991). Short-Run Share Price Behaviour: New Evidence on Weak Form of the Market Efficiency. Vikalpa , Vol.16, No.4, 17-21. [9] Deb, S. S. (2003). In Search of Weak form Efficiency in Indian Capital Market. The ICFAI Journal of Applied Finance , Vol.9, No.9, pp.31-50.
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  10. 10. 158 P K Mishra, K B Das and B B Pradhan