150 P K Mishra, K B Das and B B Pradhan
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)
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.
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
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
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.
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.
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
Return Series Based on BSE Daily Sensex -23.14  0.14 
Return Series Based on NSE Daily Nifty -23.70  0.13 
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
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.
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
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.
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