A

REPORT ON
STOCK PRICES DO NOT FOLLOW
RANDOM WALK
(USING MATLAB)

SUBMITTED BY

SUNDEEP CHINTA
(PGDMB11/058)

DILIP SAIKIA
INTRODUCTION:
This report tests the Random Walk Hypothesis for Weekly stock market
returns by comparing variance estimators derived from data sampled at
different frequencies. The random walk model is strongly rejected for
some sample period of 5 years (2005-2010) and for some sub periods for
a variety of aggregate returns and size sorted portfolios. The rejections
which are seen are largely due to behaviour of small stocks and they
cannot be attributed completely to the effects of infrequent trading or
time-varying volatilities.

We know that most of the decisions taken by investors are just because of
animal spirits and not as outcome of a weighted average of benefits
multiplied by probabilities which is nothing but efficiency of stock market
price formation. Various researches are done to support the efficient
market hypothesis.

The efficient market hypothesis (EMH) states that the security price fully
reflects all available information. The market is regarded as weak-form
efficient if the current price of a security fully reflects all its information
contained in its past prices, which means that studying the behaviours of
historical prices cannot earn abnormal returns. The implication of weak-
form efficiency is the random walk hypothesis (RWH), which indicates that
successive price changes are random and serially independent

VRATIO TEST:
The variance ratio test, vratiotest, is based on the fact that the variance of
a random walk increases linearly with time. Vratiotest can also take into
account heteroscedasticity, where the variance increases at a variable
rate with time. The test has null hypotheses of a random walk:

Δyt = et.

Test for Market indexes:

To test for random walks in stock market prices, we focus on the 260
week time span from January 3, 2005 to January3, 2010. As the sampling
theory is based on asymptotic approximations, large number of
observations is appropriate. Weekly sampling minimizes the biases
inherent in daily data. Weekly stock returns for S&P CNX Nifty are derived
from yahoo finance. Weekly returns are taken from Monday’s Closing File.
If Monday’s closing file is missing then Tuesday’s file is used.
We performed our test on the S&P CNX NIFTY index for the entire 261
week period as well as 130 week sub periods using aggregation values q
ranging from 2 to 16. Values entered are Z-stats and variance ratios in
brackets. And the values in red colour are the values that reject
hypothesis.

Number of nq q = 2 q=4 q=8 q = 16

base
Observations
260 0.2719 1.467 1.7949(1.3318 1.633 (1.4493)
(1.0169) (1.1703) )
130 - 0.0138(1.0023 - -
0.0273(0.997 ) 0.1475(0.9614 0.7017(0.7270
6) ) )
130 0.3201 1.5699 2.1141 2.2817(1.8877
(1.0281) (1.2596) (1.5527) )
Market index results for a week base observation period

The graph shows heteroscedasticity.

We observe that vratiotest rejected the hypothesis for some sub period
that a random walk model is not a reasonable model for stock series. The
rejections are not due to changing variances since the z stastics are
robust to heteroscedasticity. The estimates of the variance ratio are
almost all larger than 1. For Example the entries in the first column of
above table correspond to variance ratios with an aggregate value q of 2.
The first-order autocorrelation coefficient estimator of weekly returns is
approximately 17 percent. The variance ratios increase with q but the
magnitudes of z statistics do not. Indeed the test statistics decline with q.
Hence significance of the rejections becomes weaker as coarser sample
variances are compared to weekly variances. The rejections for this index
are primarily due to second 130 weeks of sample period.

Number of nq q = 2 q=4 q=8 q = 16

base
Observations
260 1.0841(1.140 1.2181(1.2942 1.6268(1.6430 0.8462(1.537)
 0) ) )
130 0.224(1.0418- -
) 0.5568(0.8031 0.8143(0.5083
) )
130 1.1176(1.204 1.2982(1.4590 1.356(1.8187)
1) )
Market index results for a month base observation period

Values entered are Z-stats and variance ratios in brackets.

The graph shows the presence of heteroscedasticity

The above table presents the variance ratios using a base period of four
weeks/month. Here the first entry of first row, 1.14 is the variance ratio of
2nd month price to 1st month price. With a base interval of one month we
generally do not reject the random walk model for all periods and sub
periods.

Test for size-based portfolios:

For this test we have taken BSE Small Cap stocks, BSE Mid Cap and BSE
100 stocks weekly data for same period of five years. This table shows
results for the size based portfolios using a base observation period of one
week.

H: 1 1 1 1 0 1 1 1 for IID = [1 1 1 1 0 0 0 0]
(hypothesis results for various frequencies with and without presence of
heteroscedasticity)

Evidence against the random walk hypothesis for small firms is strong for
almost all time periods considered and all the z stastics are well above 2.0
reaching 4.0. As we proceed through the results for portfolio of large
firms, the z stats become smaller and the results show that null
hypothesis is not rejected for large firms. WE can obtain estimates of first
order auto correlation coefficient for returns of all size sorted portfolios by
subtracting 1 from ratios entered in q = 2 column. The values in the
smallest quintile have a 21 percent weekly auto correlation and reaches
25 percent in sub period 2. Although the serial correlation for the portfolio
prices of midcap quintile is much smaller (13 percent) it is statistically
significant.
The results for size based portfolios shows variance ratios increasing in q
and significance of rejection decreasing in q for all these portfolios.
However when the base observation interval is increased to four weeks
our test will not reject random walk model. (Results not shown).

Number of nq q = 2 q=4 q=8 q = 16

base
Observations
260 3.3763(1.2094 3.8469(1.4463 3.9542(1.7310 3.2833(1.903)
) ) )
130 1.4873(1.1304 1.5261(1.2524 1.3470(1.3522 0.0521(1.0203
) ) ) )
130 2.8738(1.2521 3.4228(1.5660 3.8580(2.0087 4.012(2.5612)
) ) )
BSE Small Cap results for a week base observation period

Number of nq q = 2 q=4 q=8 q = 16

base
Observations
260 2.1417(1.1328 2.8257(1.3279 3.4230(1.6328 3.1155(1.8571
) ) ) )
130 0.8606(1.0755 0.9701(1.1604 1.3102(1.3425 0.9139(1.0755
) ) ) )
130 1.8200(1.1596 2.4933(1.4123 3.1484(1.8232 3.4642(2.3478
) ) ) )
BSE Midcap results for a week base observation period

Values entered are Z-stats and variance ratios in brackets.

Number of nq q = 2 q=4 q=8 q = 16
base
Observations
260 - - 0.8086(1.1495 1.0289(1.2831
1.2872(0.9202 0.0581(0.9933 ) )
) )
130 - - 0.0052(1.0014 -
0.5108(0.9552 0.0310(0.9949 ) 0.3755(0.8539
) ) )
130 - 0.0608(1.0101 0.9555(1.2498 1.3494(1.5250
0.9585(0.9159 ) ) )
)
BSE-100 results for a week base observation period

Conclusion:
By using simple Vratiotest we have rejected random walk hypothesis for
weekly stock market returns. These rejections cannot be explained by
infrequent trading or time varying volatilities. The rejection of model does
not necessarily imply the inefficiency of stock price formulation. Although
we have used vratiotest as a diagnostic tool for the random walk
specification, it is more a difficult task precisely which stochastic process
best fits the data.