Empirical test for weak forms of market efficiency
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Answer:
Efficient Market Theory: Empirical Test
Weak Form:
The weak form of the market as stated is that no investor can use any information of the past to earn a return of portfolio which is in excess of the portfolio’s risk.
This means that the investor who develops the stingy based on past prices and chooses his portfolio on that basis cannot continuously outperform another investor who ‘buys and holds’ his investments over a long-term period. In other words, technical analysis or market index will not be indicative of superior portfolio performance.
Many research studies were carried on to test the weak form of the efficient market hypothesis. The question which has rapidly been studied by the researches is whether “security prices follow a random walk”.
A random walk when it is applied to security prices means that all price changes which have occurred today are completely independent of the prices prior to this day in all respects. The weak form of the efficient market theory takes into consideration only the average change of today’s prices and states that they are independent of all prior prices.
The evidence supporting the random walk behaviour also supports the efficient market hypothesis and states that the large price changes are followed by large price changes but they do not change in any direction which can be predicted. This observation in a way violates the random walk behaviour but it does not violate the weak form of the market efficiency.
Researchers have studied that the evidence which supports the efficient market behaviour is based on the random walk behaviour of security prices but there is evidence which contradicts the random walk hypothesis, This does not mean that it contradicts the efficient market hypothesis also.
Research was first conducted in 1900 by Bachelier. He developed a theory for the behaviour of commodity prices and his research analysis showed that these commodity prices followed a random walk.
In 1934 Cowles, Jones in 1937 and Kendall in 1953 further supported that the security prices went round a random walk. Research by these analysts was purely on economic series data through which they analysed statistically properties of data and provided evidence of efficient market in its weak form.