Random Walk Hypothesis - Efficient Market

The random
walk
hypothesis is
a financial
theory stating
that stock
market prices evolve according to a random walk and thus cannot be predicted. It is
consistent with the efficient-market hypothesis. The efficient market theory is a
simple concept which says that the share prices basically reflect all the available
information -in the strongest efficient market practically all the information including
insiders information and in the weak efficient market publically available
information. So practically its impossible to beat the market.
This hypothesis is only as good as knowledge of market participants. So if market
participants dont understand economics and when the central bank does
something it is likely that they may misinterpret and imply the prices or impact
prices which may be totally wrong and even they might not realize the impact as
implication may be long term. Many times this resulted in market crisis for example
crisis of 2008. Even if we assume that there are people who understand economics
and impact but they are not significant player in market. So this correct information
is not going to impact the market. In this way the market is not efficient and its
possible to beat the market by the people who are having more information.
In this project first we are going to test the Random Walk hypothesis for NIFTY.
Random movement of share prices goes in favor of EMH(Efficient Market
Hypothesis). According to EMH if there is possibility to predict the future price of
share, that is the first sign of inefficient market. Randomness, one can say, is
necessary condition for EMH.
Random walk theory claims that stock market can be analyzed as random walk
according to next three facts:
efficient markets respond very fast to new information;

if the share price is a reflection of all available information, it is impossible to

use that information for market predictions;
it is impossible to predict market movement other than randomly.

RUN TEST
To test our hypothesis Run Test will be used
The Run test is also known as Geary test and it is a non-parametric statistical test
whereby the number of sequences of consecutive positive and negative returns is
tabulated and compared against its sampling distribution under the random walk
hypothesis. A run is defined as the repeated occurrence of the same value or
category of a variable. It is indexed by two parameters, which are the type of the
run and the length. Stock price runs can be positive, negative, or have no change.
The length is how often a run type occurs in succession. Under the null hypothesis
that successive outcomes are independent, the total expected number of runs is
distributed as normal with the following mean:

and the standard deviation

where n is the total number of observations, nA is the number of first run cycle, and
nB is the number of second run cycle. Number of runs is marked with R. If the
number of observations is large its distribution is almost equal to normal
distribution. The test for serial dependence is carried out by comparing the actual
number of runs in the price series. If the number of observations is large its
distribution is almost equal to normal distribution. That is why we can use standard
normal Z distribution for implementing the Run Test.

H0: the sequence was produced in a random manner

H1: the sequence was not produced in a random manner

Significance Level : = 5%, critical value 1.96

Null hypothesis will be rejected if

Z>1.96
Historical data for NIFTY is downloaded from NSE website from 2004. Run test for
each year is conducted separately and also for all years together. An increase in
NIFTY is marked as "1" and decrease is marked as "0".

Conclusion/Insight

We accept the hypothesis with 5% significance level till 2012 that

our market is efficient in digesting the information.
For 2013 and 2014 the null hypothesis is rejected and market
becomes inefficient (MODI effect- not economics)
On long term basis null hypothesis is rejected and there is
probability of predicting the market.

The insight from this assignment presents some interesting behavior of our
stock market. The daily movement of NIFTY is in line with the Random Walk
Hypothesis (Except for 2013 and 2014) and suggests that the movement is
random and the market cannot be predicted based on past data. The
movements in 2013 and 2014 are against the efficient market hypothesis
(not random) and suggest inefficiency. This may be because of this new
government and there may be a large number of investors expecting some
economic reform from this new government. -. This need to be investigated
further with help of some more macroeconomic parameters.
2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2004-14

127

110

111

121

121

129

127

111

126

106

97

1296

n0=

114

108

98

108

129

111

120

141

111

130

94

1245

n1=

139

143

152

141

116

131

132

106

140

119

134

1472

253
126.2
6

251
124.0
6

250
120.1
7

249
123.3
1

245
123.1
6

242
121.1
7

252
126.7
1

247
122.0
2

251
124.8
2

249
125.2
6

228

2717

111.49

1350.02

61.77

60.08

56.55

59.83

60.65

59.43

62.46

59.04

60.83

61.76

53.29

669.55

R=

n=
E(R)=
Var(R)=
StdDev(R)
=

7.86

7.75

7.52

7.74

7.79

7.71

7.90

7.68

7.80

7.86

7.30

25.88

Z=

0.09

-1.81

-1.22

-0.30

-0.28

1.02

0.04

-1.43

0.15

-2.45

-1.99

-2.09

P-value=

0.54

0.03

0.11

0.38

0.39

0.85

0.51

0.08

0.56

0.01

0.02

0.02

H0

H0

H0

H0

H0

H0

H0

H0

H0

H1

H1

H1

On a longer time horizon the market is not efficient and investors can make
money by proper technical and fundamental analysis based on past data like
volume and price.

What if one use Technical Analysis for prediction?

To further investigate and test the random walk hypothesis for NIFTY
movement in case investor uses some technical analysis and try to
understand the predictive behavior, a 5 days

simple moving average is considered for investment decision and the results
are significantly against the random walk hypothesis and the hypothesis can
be rejected with very high significant level. The movement is almost
predictable and our market is not efficient. Investors can make big money by
predicting the market by using technical analysis as simple as simple moving
average.
R=
n0=
n1=
n=
E(R)=
Var(R)=
StdDev(R
)=
Z=

466
1124
1589
2713
1317.6
5
638.73
57
25.273
22
33.697

P-value=

7
3.1E249

A very large Z value and p value almost equal to zero!

Happy investing- -