Submitted By

Adil Khan

Roll Number:

Share Market Efficiency: Is the Indian

Capital Market weak form efficient?

PhD Research Proposal

Submitted to

Centre of Management Studies

Jamia Millia Islamia

New Delhi

on

23-Aug-13

This proposal aims to test the efficiency of Indian Stock Market and to understand

the extent to which reality is close to the theoretical ideas of an efficient capital

market. For a market to be efficient it has to be large and liquid. Information has

to be widely available in terms of accessibility and cost, and released to investors

at more or less the same time. Transaction costs have to be cheaper than the

expected profits of an investment strategy. Investors must also have enough funds

to take advantage of inefficiency until, it disappears again

1

Contents

1. TOPIC OF RESEARCH 2

2. PROBLEM STATEMENT/RESEARCH QUESTIONS 2

3. RESEARCH OBJECTIVES 2

4. BACKGROUND 3

5. CURRENT STATE OF THE LITERATURE RELATED TO THE PROPOSED TOPIC 6

6. PROPOSED RESEARCH WORK 9

7. METHODOLOGY 9

8. REFERENCES 11

9. OTHER RESOURCES AND TOOLS 12

2

1. Topic of Research

Share Market Efficiency: Is the Indian Capital Market weak form efficient?

2. Problem Statement/Research Questions

This proposal aims to test the efficiency of Indian Stock Market and to understand the extent

to which reality is close to the theoretical ideas of an efficient capital market.

The main Purpose of this research is to understand the stock markets and to provide certain

guidelines to small retail investor. In Indian setting we would try to discover the answers of

following questions.

1) Is Indian capital market truly efficient? (Or in other word is it efficient at all or not?)

2) To which extent, the Indian capital market is efficient. (I.e. The form of efficiency)

3. Research Objectives

As discussed earlier, the main aim of the research is to understand the stock markets and to

test their degree of efficiency. In this regard some of the long held theories will be tested and

deductions will be made as a result of an extensive research of the ground reality.

There are many important aspects of stock market that will be examined in order pursue the

research and achieve desired objective.

1) Political conditions of India and its global relation especially with USA.

2) The Status of the current Indian Stock market

3) Trends in the Indian Stock market for the last few years.

4) A brief overview of the Indian Capital market post liberalization.

5) Extent of the availability of information to the buyers and sellers

6) Extent of irrationality in the market

7) Analysis of the high performing companies in the market

8) Analysis of the availability of unique information and the existence of outperformers

9) Extent of reflection of future information through stock prices

10) Analysis of the barriers to the existence of an amateur

11) Test of the extent to which stock price movements are random or trendy

3

Qualitative data

Interviews and open ended questions and their analysis for making them comprehendible. A

number of people will have to be interviewed and a broad qualitative analysis would be

required to achieve the goal of this research

This will help putting forth a strategy as a recommendation for future course of action to help

the investors in their venture in the Indian market.

4. Background

„Market Efficiency‟ is the key term that will appear very often throughout the research. The

concept of Market Efficiency (or more precisely Efficient Market Hypothesis) was

introduced by Eugene Fama.

Stock Market is a term that refers to a concept for the mechanism that enables the trading of

company‟s stocks (collective shares), other securities, and derivatives. Stock markets take

their roots from the early 17th Century and today the worldwide market is estimated to have a

value of excess of $51 trillion.

Economists define market as a place where buyers and sellers meet and a transaction is

reached between the two, the same theory applies to a stock market. It offers a platform for

the buyers and sellers of stocks to interact and cause a transaction. These buyers and sellers

are mostly the investors and institutions but the ordinary even has access to the stock

exchange.

Stock exchange is the heart of a stock market, it is a physical location where transactions are

carried out on a trading floor, by a method known as open outcry. This type of auction is used

in stock exchanges and commodity exchanges where traders may enter verbal bids and

tenders simultaneously. By a general rule buyers would buy only if they feel they are

underpaying and sellers would sell when they think they are being overpaid, a negotiation

between the two is the key and this is brought about by the existence of a broker.

Now trader can trade online because most of the Stock Exchanges are providing online

trading facility for instance BSE has started B.O.L.T system which facilitates online trade.

4

Like commodity market, the market for stock is also subject to variations in prices and the

success of the market revolves around the successful prediction of future price trends. This

deduction is made with the help of information available in the market.

By the definition of economics a market is efficient when the prices of commodities

accurately reflect the current information and the conditions prevailing in the market.

Viewing it in terms of the Capital Market it refers to a market in which new information is

very quickly and accurately reflected in share prices.

For a market to be efficient it has to be large and liquid. Information has to be widely

available in terms of accessibility and cost, and released to investors at more or less the same

time. Transaction costs have to be cheaper than the expected profits of an investment

strategy. Investors must also have enough funds to take advantage of inefficiency until, it

disappears again. Most importantly, an investor has to believe that she or he can outperform

the market. Outperforming refers to the ability of an investor to take advantage of the

fluctuating prices. An efficient market is assumed to be free of out-performers and this is

where the real objective of the report comes in i.e. determining whether the markets are

efficient, inefficient or a compromise.

Stock markets throughout the world at large are not free of out-performers. Giant investors

are dominating stock markets throughout the world, in these circumstances it becomes

important to determine whether the existence of out-performers just another aspect of

efficiency or is it the main reason for the fierce stock market crashes of the 20th century.

Importance of Stock Market Efficiency

Last two decades and especially the dawn of the 21st century has seen a lot of interest

developing in the stock markets and investments in this sector of the economy has increased

to record levels it is thus imperative to the determine the efficiency of the market, as it affects

the economy of a country at large. Three possible reasons can be cited that account for the

importance of the Capital Markets.

To motivate investors, especially small retail investors

Accurate pricing is required if individuals are to be encouraged to invest. If shares are

incorrectly priced, many potential candidates will refuse to invest due to the fear of a perverse

price at the time selling, which may not represent the fundamental attractions of the firm.

Such an action seriously reduces the availability of funds to companies and inhibits growth.

5

Investors need to be confident that they are paying a fair price and that they will be able to

sell at a fair price. Thus an efficient gives investors a chance to play a fair game. Provisions

regarding this aspect would improve the stakeholders trust in the company and larger

investments would hence result in the economic growth that would benefit the company and

the economy at large.

To give correct signals to company managers

The maximization of shareholder wealth will be represented by the share price in an efficient

market and thus sound financial decision-making relies on the correct pricing of the

company‟s shares. In implementing a shareholder wealth-enhancing decision the manager

will need to be assured that the implication of the decision is accurately signaled to

shareholders and stakeholders through a rise in the share price. It is important that managers

receive feedback on their decisions from the share market so that they can be encouraged to

pursue with shareholder wealth strategies.

To help allocate resources

Allocation efficiency requires both operating efficiency and pricing efficiency. If a poorly

operated company in a waning industry has highly priced shares because the stock market is

not pricing appropriately then this firm will be able to issue new shares, and thus attract more

of society‟s savings for use within its business. This would be socially unethical as the money

spent in the company could have been better utilized elsewhere, but with the current company

the invested sum would inevitably be wasted.

All the above points stress the importance of efficiency in the stock market and hence

highlight the functionality and relevance of the research work to be carried out as its

implications to the market are huge.

Researches have been conducted previously and various theories have been developed to

trace the behavior of stock markets. One of the most theories in this regard is the Efficient

Market Hypothesis (EMH), formulated by Eugene Fama in 1970. Thus, according to the

EMH, no investor has an advantage in predicting a return on a stock price since no one has

access to information not already available to everyone else.

The above stated theory is widely accepted but, whether this theory actually holds true is

what will be tested as one of the most important aspects of this research. EMH undermines

6

the role of investors in the market and the above theory has been tested and analyzed

throughout the years by various researchers, hence a lot of published material is available in

this regard which will be utilized in analyzing it.

Study of political situation in India

Political stability is the major differentiating factor between an efficient and inefficient

market. Instable political conditions especially in the Third World countries results in the

stock markets being manipulated by the certain powerful groups. It is imperative to study the

effect of political situations on market efficiency.

Anomalies

A number of anomalies result in the irrational behavior of the market, whether or not such an

attitude is applicable in the US market and he extent of it pertinence will be tested through a

comparison of the stock market patterns and political conditions for the past five years.

5. Current state of the literature related to the proposed topic

Eugene Fama (Fama 1965) propounded his famous efficient market hypothesis for US

securities, a number of empirical research have been carried out to test its validity, mainly in

the developed countries with booming financial markets (Summers, 1986; Fama and French,

1988)

Fama classified stock market efficiency into three forms. They are namely „weak form‟,

„semi-strong form‟ and „strong form‟. The classification depends upon the underlying

assumptions relating to information set available to market participants.

Weak Form Efficient Market Hypothesis, which is also known as Random Walk Hypothesis

(RWH) states that present prices of securities fully reflect information contains in the their

historical price.

Therefore, the best predictor of the future price is the present price. It is not possible for the

investors to design profitable strategy on the basis of past price of a security. Random walk is

the path of a variable over time that exhibits no predictable pattern at all. If a price moves in a

random walk, the value of price in any period will be equal to the value of price in the period

before, plus or minus some random shocks.

7

Semi-strong Efficient Market Hypothesis claims that prices of securities incorporate publicly

available information, while strong-form holds that all the information set whether public

or/and private are enveloped in the market prices of securities. Hence the prediction of future

price conditional on past information is not advantageous to market participants. The more

efficient capital market is more random which makes the market return more unpredictable.

In the most efficient stock market, future prices will be purely random and the price

formation can be assumed to be a stochastic process with mean in price change would be

equal to zero.

Fama (1991) renamed the market efficiency studies into three categories. The first category

involves the tests of return predictability; the second group contains event studies and the

third tests for private information.

The concept of random walk was first developed by Bachelier. He found that a successive

price change between two periods is independent with zero mean and variance depends upon

interval between two periods.

The early studies on testing the weak form efficiency on the developed stock markets,

generally agree with the support of weak-efficiency of the market considering a low degree of

serial correlation (Cootner, 1962; Fama, 1965 and 1970).

Porterba and Summers (1988) confirmed the presence of mean reverting tendency and

absence of random walk in the U.S. Stocks.

Lo and McKinney (1988) proposed variance ratio test to test random walk hypothesis. Their

findings provided the evidence against random walk hypothesis for the entire sample period

of 1962 to 1985.

Fama and French (1988) discovered that forty percentage of variation of longer holding

period returns were predictable from the information on past returns for U.S. Stock markets.

Kim, Nelson and Startz (1991) examined the random walk pattern of stock prices by using

weekly and monthly returns in five Pacific-Basin Stock Markets.

Pope (1989) noted that the traditional tests of random walk model such as serial correlation

and run test are susceptible to error because of spurious autocorrelation induced by non-

synchronous trading.

8

Shiller and Perron (1985) and Summer (1986) have demonstrated that such tests have

relatively little power against interesting alternative hypothesis of market efficiency.

Madhusudan (1998) found that BSE sensitivity and national indices did not follow random

walk. Using correlation analysis on monthly stock returns data over the period January 1981

to December 1992, Olowe (1999) shows that the Nigerian stock market is weak form

efficient.

Bhanu Pant and Dr. T.R.Bishnoy (2001) analyzed the behaviour of the daily and weekly

returns of five Indian stock market indices for random walk during April 1996 to June

2001.They found that Indian Stock Market Indices did not follow random walk.

Shigguang Ma and Michelle Barnes (2001) tested both Shanghai and Shenzen stock market

for efficient market hypothesis using serial correlation, runs and variance ratio test to index

and individual share data for daily, weekly and monthly frequencies and found that Chinese

stock markets were not weak form efficient.

Osei(2002) investigated the asset pricing characteristics and response to annual earnings

announcement of the Ghana Stock market. He concluded that Ghana Stock Market is not

efficient with respect to annual earnings information releases to the Ghanian Market.

Madhumita Chakraborty (2006) investigated the stock price behaviour using daily closing

figures of Milanka Price Index during January 1991 to December 2001 and daily closing

prices of twenty-five underlying individuals companies included in the index from July 1991

to May 1999. The study found that stock market in Srilanka did not follow random walk,

while results of weak form efficient market hypothesis in twenty-five companies showed

mixed outcome.

Daniel Simon and Samuel Laryea (2006) examined the weak form of efficient market

hypothesis for four African stock markets-Ghana, Mauritius, Egypt and South Africa. Their

results implied that South African market was weak form efficient, whereas that of Ghana,

Mauritius and Egypt were weak form inefficient.

The above literature will be used as the basis to proceed with research that primarily aims at

determining the degree of efficiency in the real markets, the extent to which stock prices are

susceptible to irrationality and outperforming and the level of pertinence of EMH in the real

markets.

9

6. Proposed Research Work

I have listed below, a series of activities which will be required to accomplish the research

work. The list below is indicative only and there may be additions or deletions in this list.

Further certain events may not follow the same order or sequence and may overlap.

1. Synopsis Submission

2. Course work

3. Research methods of data collection

4. Secondary Research:

5. Write up findings

6. Primary Research/Data Collection:

7. Write up interview questions

8. Contact for interview permission

9. Carry out interviews

10. Find volunteers for Focus Group

11. Write up discussion topics

12. Conduct Broker interviews

13. Write up findings

14. Thesis written and typed

15. Proof reading and Correction

16. Approval from Supervisor

17. Binding

18. Submission

7. Methodology

The essence of methodology is structuring one‟s actions according to the nature of the

question at hand and the desired answer one wishes to generate. (Jan Jonker 2010). The focus

of this section is to determine how the data would be collected, gathered and analyzed.

Selection of correct data collection procedure is the key so as to hit the right spot and to

collect relevant information. The data collection would involve both primary and the

secondary research.

10

Secondary Research

This research would more be based on qualitative factors and procedures for data gathering

rather than numbers and quantifiable values. There are loopholes of this procedure such as:

Extensive complexity associated to analyzing the qualitative data, because comprehension of

qualitative data and its judgment depends on the nature and knowledge of the individual

analyzing it. There are no standardized data categories or collection mechanisms within the

predefined methods and techniques of data collection.

For the maximum appropriateness and to eliminate the biasness associated to the judgment of

data, the initial data gathering shall be through publications published electronically as well

as in forms of magazines, and web links. The findings from this literature shall be merged

with the data collected from other sources primarily to eliminate biasness of opinion (as

mentioned earlier) and to add credibility and authenticity to the findings.

A number of magazines and journals have been selected the details of which has been

provided in the bibliography in the end.

One limitation associated with the secondary research is the absence of latest information and

point of views of the people involved in order to determine a primary research will also be

conducted.

Primary Research

A number of methods will be utilized in collecting data from the ground sources, these are:

Personal Interviews with the managers of companies. A panel interview with a number of

brokers. A Telephone Interview with some influential capital market personals

One of major limiting factor in the above is that of time, as it will be difficult to get time from

these personals. Moreover designing a questionnaire will also be a complex task as it will be

required to cover the relevant points presented in the best way possible. Finally analysis of

the qualitative data would again be a difficult task for which published help will be taken and

a conclusion would be based on the results of the primary and secondary research.

11

8. References:

1. Bollerslev,T.(1986). “Generalised Autoregressive Conditional Heteroscedasticity”,

Journal of Econometrics

2. Campbell, J.Y. A.Lo. and A.C.Mackinlay,(1997),”The Econometrics of Financial

Markets”,Princeton University Press, Princeton, New Jersey

3. Cootner P.,(1962),”Stock Prices : Random vs. Systematic Changes. Industrial

Management Review, 3 (Spring)

4. Cutler, D.M.,Porterba, J.M. and Summers, L.H.(1990),”Speculative dynamics and the

role of feed back traders”, American Economic Review, Vol.80(2).

5. Daniel Simons and Samuel Laryea(2006), “ The Efficiency of Selected African Stock

Markets”, Finance India, VolXX(2)

6. Fama, E.F.,(1965), “The Behaviour of Stock Market Prices”, Journal of Business,

January 1965

7. Fama, E.F.,(1991), “Efficient Capital Markets II”, Journal of Finance, Vol.46(5)

8. Fama, E.F.and K.R.French,(1988), “Permanaent and Temporary Component of Stock

Prices”, Journal of Political Economy, Vol.96

9. Kim, M.J.Nelson, R.C. and Startz.,(1991), “Mean reversion in stock prices? A

reappraisal of the empirical evidence”,The Review of Economic Studies, Vol.58.

10. Lo, A.W. and MacKinlay, A.C.,(1988), “Stock market prices do not follow random

walks:Evidence from a simple specification test”, The Review of Financial Studies,

Vol.1(1)

11. Olowe(1999),”Weak Form Efficiency of the Nigerian Stock Market: Further

Evidence”,African Development Review, Vol.11(1)

12

12. Pope(1989),” A reappraisal of the efficiency of financial markets, Berlin, Heidelberg:

Springer Verlag

13. Shiller, R.J. and Perron, P.,(1985),”Testing Random walk hypothesis:Power Versus

Frequency of observation, Economic letters,Vol.18(4)

14. Summer, L. H. (1986),”Does the stock market rationally reflect fundamental values?”,

The Journal of Finance, Vol.41(3)

9. Other resources and Tools

1. Standard Texts

2. Academic Journals

3. Published Articles

4. Published Journals

5. Magazines

6. Internet Resources

7. Online Databases

8. SPSS/Excel and other software