CHAPTER 1INTRODUCTION

1.1 Efficient Markets Hypothesis:An investment theory that states it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices.As such, it should beimpossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments.Although it is a cornerstone of modern financial theory, the EMH is highly controversial and often disputed. Believers argue it is pointless to search for undervalued stocks or to try to predict trends in the market through either fundamental or technical analysis.

Meanwhile, while academics point to a large body of evidence in support of EMH, an equal amount of dissension also exists.For example, investors, such as Warren Buffett have consistently beaten the market over long periods of time, which by definition is impossible according to the EMH. Detractors of the EMH also point to events, such as the 1987 stock market crash when the Dow Jones Industrial Average (DJIA) fell by over 20% in a single day, as evidence that stock prices can seriously deviate from their fair valuesBefore taking any investment decision every investor has to use some investment techniques for evaluating the securities. Two different approaches in use for investment decision making are fundamental analysis and technical analysis. Fundamentalist use the intrinsic value of securities for identifying the securities to be purchased or sold. The technical analyst believed in the past behavior of the prices. However in real life decision making is not guided by a single tool fundamental or technical, but other qualitative factors requiring a lot of personal judgment. In this research work we study the third approach Efficient Market Hypothesis.Markets are considered to be efficient if there is a free flow of information and the market absorbs the information quickly. Market efficiency signifies: how quickly and accurately does relevant known information in immediately discounted by all the investors and reflected in the security prices in the market. No single investor has an information edge over the others as everyone knows all possible to know information simultaneously. Moreover every investor interprets the information similarly and behaves rationally.

1.2 Financial Market Efficiency:Financial market is a market for the exchange of capital and credit, which consists themoney marketsand thecapital markets. Money market is the market for short-term debt securities, which is a typically safe and highly liquid able investment. While capital market is the market where long-term debt or securities are traded.Market efficiencyrefers to a condition, in which current prices reflect all the publicly available information about a security. The basic idea underlying market efficiency is that competition will drive all information into the price quickly.In the financial market, the maximum price that investors are willing to pay for a financial asset is actually the current value of future cash payments that discounted at a higher rate to compensate us for the uncertainty in the cash flow projections. Therefore what investors are trading actually information as a "commodity" in financial market for the future cash flows and information about the degree of certainty?Efficient marketemerges when new information is quickly incorporated into the price so that price becomes information. In other words the current market price reflects all available information. Under these conditions the current market price in any financial market could be the best-unbiased estimate of the value of the investment.

1.3 Definitions of Market Eficiency :According to James LorieEfficiency means the ability of the capital market to function, so that prices of securities react rapidly to new information. Such efficiency will produce prices that are appropriate in terms of current knowledge and investor will less likely to make unwise investment.

According to E.F.Fama Efficient markets is defined as the market where there are large numbers of rational profit maximizes actively competing with each trying to predict even the market value of individual securities and where current information is almost freely available to all participants. In an efficient market scenario, all instruments in the market will be correctly priced as all the available information is perfectly understood and absorbed by all investors, present as well as prospective. No excess profits are possible in this scenario. A security price will be a good estimate of its investment value where investment value is present value of the securitys future prospects as estimated by well informed and capable analysts. Any substantial disparity between price and value would reflect market inefficiency. Alert analysts would seek to make advantage of this inefficiency, immediately. Under priced securities will be purchased creating pressure for price decline due to increased supply to sell. Thus, in a perfectly efficient market, analyst immediately competes away any chance of earning abnormal profits. Efficient market operates on following assumptions :- Information must be free and quickly to flow so that all the investors can react to the new information. Transaction costs such as sales commission and bottlenecks are not there. Taxes have no noticeable impact on investment policy. Every investor can borrow or lead at same rate. Investors must be rational and behave in a cost effective competitive manner. Market prices are efficient and not sticky and absorb the market information quickly and absorb the market information quickly and the market responds to new technology, new trends, changes in tastes etc.In the efficient market, the forces of demand and supply move freely and in an independent manner.

1.4 Random Walk TheoryThe basis of random walk theory is that the markets information is immediately and fully spread so that all the investors have full knowledge of the information. As per this theory, changes in stock prices are independent of each other. The prices of today are independent of past trends. The price of each day is different it may be higher or lower than the previous price or may be unchanged. The present price is randomly determined and is influenced only by the information. This theory has been empirically tested and the analysts have also found an explanation for the efficiency of the markets. As the equilibrium price of the security is determined by demand and supply forces based on available information, this equilibrium price will immediately change as fresh information becomes available. Based on the fresh information, a new equilibrium price will be reached which is totally independent of the past price. The random walk theory totally contradicts technical analysis which believes that present prices are based on the past trends and the history of trend repeats itself.Random Walk theory is based on certain assumptions: There is a perfectly competitive market operating in an efficient manner in order to equate the actual stock prices with its present discounted value. Market is supreme and no individual investor or group p can influence it. All investors have the same information and nobody has superior knowledge so that the prevailing market prices reflect the stock present value. Stock prices discount all the information quickly. A price change occurs in the value of stock only because of information relating to fundamentals which affect the company or the stock markets. The price moves in an independent fashion without undue pressure. The instant changes in the stock prices are recognizing the fact that all available information is reflected in the stock prices. Institutional investors or major fund managers have to follow the market and cannot influence it. The changes in the stock prices show independent behavior and are dependent on the new pieces of information that are received but within themselves are independent of each other. Whenever a new piece of information is received in the stock market, it independently receives this new information and this is independent and separate of all other pieces of information.This rapid shift to a new equilibrium level whenever new information is received is the random walk theory.The random walk theory is based on efficient market hypothesis. EMH says that successive absolute short run prices changes are independent. The hypothesis is based on the assumptions that all the securities markets are efficient. To have efficient markets, it is essential that both internal and external efficiency must be there:-Internal efficiency: Internal efficiency refers it the market where the transaction costs are low and transaction move at a very high speed. Investor has no control over this type of efficiency.External efficiency: Markets are considered to be externally efficient if they absorb all the information in an unbiased manner. In such market, the new information is immediately reflected in the security prices. The price adjusts to the new information only when the investors are rational and markets are efficient.E.F Fama has provided that the efficiency of markets depends on the extend of absorption of information. The time taken for absorption and type of information absorbed. The absorption of information by the market is of different degrees.

1.5 Fama has given three Classification of Efficiency:WEAK FORM: The form of the market is the oldest statement. This form of market holds that current price of stock fully reflect all historical information thus, past data cannot be used to predict future prices.In the other words of Adam Smith, prices have no memory, and yesterday have nothing to do with tomorrow. This form asserts that any attempts to predict prices based on historical information are totally futile as future prices changes as independent of past price changes. The weak form contradicts the technical analysis, which states that price move in a predicated manner and historical price movement, can help to forecast future price trends.The weak form of efficiency hold good in any market, since even the critics of EMH admit that price adjust to the information ultimately. Empirical evidence has shown that as the past prices are already absorbed by the market the price moves in a independent fashion. Both EMH in its weal form and random walk theory postulates that analyzing the past does not improve the forecasting ability of stock prices and new information and prices that result from them cannot be predicted.

SEMI-STRONG FORM: The semi-strong form of EMH postulates that market absorbs quickly and efficiently all the publicly available information, as well as the information regarding historical prices. As prices adjust to the information quickly and accurately abnormal profits cannot be earned on a consistent basis. The empirical evidences support the convention that public react quickly to the new information. But there has been some evidence that market does not always digest the new information correctly. The inefficiency in the market mechanism in absorbing the data is found to be correct over a period of time, as the investor take time to analyze and conclude the effect of any public information.The semi-strong form is not empirically well supported but in many foreign markets semi-strong form is found to be applicable and market quickly absorbs all public information .The revolution in information communication technology has made the application of semi-strong possible in developed countries.

STRONG-FORM: The strong form of EMH represents the most extreme case of market efficiency possible. According to the strong form the prices of the security fully reflect all available information both public and private. if this form is true, prices reflect the information that is available to the select group like Management, financers, stock exchange official etc. thus according to this form no information that is available be it public or inside can be used to consistently earn superior investment returns. This implies that not even security analyst and portfolio managers, who have access to information more quickly than the general public are able to use this information to earn superior returns. Studies made in developed countries have shown that strong form of efficient market does not exist their also. Investor has not shown consistently higher returns even with all the information available to them. It was also found that average investor could do better by picking up securities in random fashion.In the strong form two basic conditions are there (i) successive price changes or return are independent(ii) the successive price changes or return changes are identically distributed.

1.6 Testing techniques of EMH :EMH states that successive price changes are independent in the short run subject to the assumption that market comprises of rational investors. However in reality investors are not always rational for selecting the securities they consider a number of other factors also in addition to risk and return. It is very difficult if not impossible to segregate the fractional influences of these factors. In the stock market particularly in the Indian stock market sentiments play a major role in price behavior. There several techniques for measuring the EMH. The techniques can be direct and indirect. Direct assess the success of specific investment strategies or trading rules. Indirect test are statically test of prices or returns.

Test of weak formsRun TestRun test is the test for measuring the successive price changes. In this test, the sample for randomness is tested. The dictionary meaning of run is a sequence by different occurrences or by none at all. A run is thus a consecutive sequence of price changes of the same sign. Unlike correlation test, run test ignored the absolute value of signs. The run tests are took into research only the positive and negative signs. The run test is made by counting the numbers of consecutive signs or runs in the same direction. Under the hypothesis of independence of successive price changes, the distribution of total numbers of runs is approximately normal. For testing the randomness of stock prices, we take a series of stock prices. Starting with the first price each price change is denoted by +, - or zero signs.Plus signs indicate that the price under consideration has increased as compared to the preceding price; negative price indicates that the price has decreased as compared to the preceding price. In case the run has changed from a plus to minus or from minus to plus, a new run is counted to have begun.In this test the actual numbers of runs are compared with the expected number of runs of all types and if the actual number of runs is significantly different from the expected number of runs, the successive price changes are not considered to be independent. If the actual numbers of runs are not significantly different from the expected number of runs, then the price changes are considered to be independent or random.

Unit Root Tests:A unit root test is a statistical test for the proposition that in an autoregressive statistical model of a time series, the autoregressive parameter is one. It is a test for detecting the presence of stationarity in the series. There are three different unit root tests used to test the present of a unit root namely, ADF, Phillips-Perron (PP) test and the Kwiatkowski, Phillips, Schmidt and Shin (KPSS) test. The presence of unit root in a time series is tested with the help of Augmented Dickey-Fuller Test. It tests for a unit root in the univariate representation of time series. The null hypothesis is H0: = 0 and H1: