Do Stocks Follow the Random Walk in Latvian Stock Market Abstract Author of the paper is testing whether successive

price changes of Riga Stock Exchange (RSE) quoted stock prices are serially uncorrelated that is they follow the random walk. The serial correlation of successive price changes will indicate that stock price changes are predictable based on their past movements and contrary weak or insignificant serial correlation will indicate the unpredictability of future stock price changes based just on their past changes. Author found that serial correlation is statistically significant in daily, monthly, bimonthly and quarterly successive stock price changes in the period 02/04/96-09/02/04. However daily serial correlation is relatively very small in absolute terms and most probably economically insignificant. Further tests of serial correlation in shorter sub periods showed that huge part of serial correlation of stock price changes are due to the early period of stock price changes and relatively minor part of serial correlation is due to the stock price changes in the last 3-4 years of research period. However monthly and bimonthly stock price changes still indicate their predictability based on their past changes also in different sub periods which implies that RSE quoted stock prices do not follow the random walk. Keywords Random walk, Riga Stock Exchange, Stock prices Mathematicians and physicists understand the random walk as a random process of a sequence of discrete steps of fixed length [14] but economists usually use the term in explaining stock market behaviour. A stock market where successive price changes in individual securities are independent is, by their definition, a random walk market. Most simply the theory of random walks implies that a series of stock price changes has no memory-the past history of the series cannot be used to predict the future in any meaningfull way. The future path of the price level of a security is no more predictable than the path of a series of cumulated random numbers [8,76]. The first researcher who linked the random walk process to economic processes was French mathematician Louis Bachelier in his Ph.D. dissertation titled "The Theory of Speculation" (1900) [4;5] who noticed that changes of prices of French government papers (rentes) behave alike molecules in the Brownian motion and are unpredictable what forced him to conclude that "The mathematical expectation of the speculator is zero". However his research remained largely unknown untill sixties of 20th century. Only in the 1934 Holbrook Working [13] found that succesive stock prices changes are independent and uncorrelated what caused him to conclude that they are like generated randomly. The conclusions of Working (1934) [13] were supported later by Kendall (1953) [9], Roberts (1959) [12], Osborne (1959) [11], Cootner (1962) [3], Fama (1965) [7;8] and others. Their researches mostly concentrated on the statistical approach to testing stock price independence. However later researches of Lo and MacKinlay (1988) [10] showed that stock prices do not follow the random walk in the long run.

The author decided to investigate is the random walk applicable also to the Latvian Stock market and performed the statistical tests of serial correlation among successive returns on the RSE quoted stocks. However the previous researches used natural logarithms of succesive price changes the author found that it will more precise to use successive stock index changes. Besides the author noticed that existing RSE stock market indices are not good indicators of the return on the stocks investigated as the existing indices do not take into the account dividends paid and the structure of the indices is changing over time. In order to avoid these difficulties the author elaborated new stock market index based on the formulas given in appendix. To ensure that the index is representing most liquid and most actively traded RSE quoted stocks the author raised following criteria for the inclusion in the index: 1. trading turnover per session is at least 0.01% of the average of all outstanding shares during listing period 2. stock price should be set on average in at least 1 3 of all trading sessions when company is listed in RSE (block trades excluded) 3. company has quoted for at least 2 years in RSE Finally 85 RSE ever listed companies were examined and only 15 of them were selected for inclusion in the selected index. It should be noted that nor Ventspils Nafta nor Latvijas Kugnieciba nor Latvijas Gaze shares were able to meet raised criteria (their average outstanding shares turnover per one trading session was more then twice as low as minimum requirement for including in the index) however their joint market capitalization calculated by their RSE stock prices comprise approximately 90% of DJIRSE capitalization. Of course one can argue that companies with very big outstanding share amount probably can not ensure the same shares turnover ratio as the smallest companies but from the other side their capitalization is depressing the impact of any other company price movements reflection in any capitalization index and if these big companies are not as half as liquid as the most illiquid shares included in the index then by authors opinion the index without such big shares will better describe the average stock market returns. In order to calculate the stock index return the author used the following formula:
It rt = I 1 100% , where t 1 return on the stock index during time period t rt stock index value at the end of the period t It

I t 1

stock index value at the end of the period t 1

The autocorrelation among returns on the stock index was calculated according to the following formula:

k =
k

k = 0

(Y

Y )(Yt + k Y ) , where [6, 714-715]

n 2 (Yt Y ) n

k =

(Y

Y Yt + k Y n

)(

autocorrelation coefficient at lag k ; stock return co variation at lag k ; dispersion of stock return.

0 =

(Y

)2

The standard error of the autocorrelation coefficient was calculated based on the Barlett methodology: k 1 1 [2] var(rk ) = 1 + 2 rl 2 ,where n l =1 variance of autocorrelation coefficient var(rk ) n number of time periods 2 rl squared autocorrelation coefficient

r
l =1

k 1

sum of squared autocorrelation coefficients at lags k 1

and the standard error is the square root of the variance:

std .error (rk ) = var(rk ) [6]

First of all the author examined the autocorrelation present among daily stock market returns. Author calculated autocorrelation coefficients among daily stock index returns at various lag levels. Results are illustrated in Figure 1 below.
Daily Return (Index 15)
.15 .13 .11 .09 .07 .05 .03 .01 -.01 Confidence Limits

ACF

-.03 -.05 1 3 5 7 9 11 13 15 17 19 21 23 25 Coefficient

Lag Number

Fig. 1 Daily Stock Return Autocorrelation at lags 1 to 25, 02-Apr-96 till 9-Feb-04

As we can see from the Figure 1 then daily stock returns at various lag levels are statistically significantly autocorrelated as autocorrelation coefficients are outside the confidence intervals which show the 95% probability (1.96 standard errors of autocorrelation coefficient from zero) that autocorrelation coefficients are statistically insignificant. Especially significant is the autocorrelation coefficient at lag 1 as the probability of reaching such autocorrelation coefficient randomly is practically zero. This result indicates that daily stock market returns are not independent and can be used to make forecasts of next trading session stock returns. However the author wants to point out that the autocorrelation coefficient value at lag 1 is not high in absolute terms (around 0.14) and as it is already mentioned by finance professor Eugime Fama the random walk model may be acceptable even though it does not fit the facts exactly (there is present some autocorrelation) cause the independence assumption of the random walk model is valid as long as knowledge of the past behavior of price changes cannot be used to increase expected gains [7;8]. The author will not investigate the practical implications of this autocorrelation at this paper however. Next the author assesed autocorrelations of monthly, bimonthly and quarterly stock market returns in order to realize does the autocorrelation is present only in short term returns or it is also present in longer period returns. Figures 2, 3 and 4 show the calculated autocorrelation coefficients at various lag levels for monthly, bimonthly and quaterly stock market returns. We can see that there is present statistically significant autocorrelation of monthly returns at lag 1 e.g. autocorrelation between successive monthly returns which is statistically significant even at 99.9% confidence interval (it is outside this interval). Besides the absolute value of the autocorrelation coefficient between successive monthly stock market returns is relatively high 0.428. The autocorrelation is not so significant for bimonthly and quarterly stock market returns as we can see from Figure 3 and Figure 4. However we can see that autocorrelation coefficients for bimonthly stock market returns are outside the 95% confidence interval at lags 1 and 2. That means that there exists some dependence in stock market returns between previous 2 and 4 month returns. The autocorrelation between quarterly stock market returns is quite curious as there is significant autocorrelation present at lag 2 which means that quarterly stock market returns were dependent on quarterly stock market returns 2 quarters ago.

Monthly Return (Index 15)

.50 .40 .30 .20 .10 .00 -.10 -.20 -.30 Confidence Limits

ACF

-.40 -.50 1 3 5 7 9 11 13 15 17 19 21 23 25 Coefficient

Lag Number

Fig. 2 Monthly Stock Return Autocorrelation at lags 1 to 25, Apr-96 till Jan-04

Bi-Monthly Return (Index 15)

.50 .40 .30 .20 .10 .00 -.10 -.20 -.30 Confidence Limits

ACF

-.40 -.50 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Coefficient

Lag Number

Fig. 3 Bi-monthly Stock Return Autocorrelation at lags 1 to 15, Apr-96 till Jan-04

Quaterly Return (Index 15)

.75 .60 .45 .30 .15 .00 -.15 -.30 -.45 Confidence Limits

ACF

-.60 -.75 1 2 3 4 5 6 7 8 9 10 Coefficient

Lag Number

Fig. 4 Quarterly Stock Return Autocorrelation at lags 1 to 10, 2nd quarter 1996 till 1st quarter 2004

Based on the analysis made so far we can conclude that Latvian stock market returns are not independent and do not follow random walk especially successive stock market returns however the practical implications of that should be tested separately. The analysis shows that there is theoretically possible trading strategies which can generate additional income to the investors if they take into the account the correlatedness of stock market returns. Previous researches of stock market return autocorrelation have not investigated the stability of the autocorrelation in time. The author wanted to check whether the autocorrelation discovered in the previous analysis in not due to some particular time periods and the autocorrelation is insignificant in remaining time periods. The author divided the research time period from 02/04/96 till 02/09/04 in shorter subperiods and examined the presence of stock market returns autocorrelation in different time subperiods at time lag 1 (autocorrelation of successive stock market returns). First of all the author splitted all research period in subperiods with the minimal length of 3 months like subperiod from 09/04/96 till 02/07/96, 09/04/96 till 01/10/96, 02/07/96 till 01/10/96 etc. Thus were examined 496 subperiods of daily stock market returns and 311 of 496 calculated stock market daily returns autocorrelation coefficients were statistically significant (they were outside 95% confidence interval) int.al. 306 positive and only 5 negative autocorrelation coefficients. The limited space does not allow to the author to publish all results of the research here however the author wants to point out that the daily stock market returns were especially statistically significant in the time period between 02/01/97 and 01/04/97 (autocorrelation coefficient 0.554 and standard error 0.131) but in the periods before and after the mentioned time period the autocorrelation of stock market returns were not so significant and in many subperiods even insignificant. Similar results were obtained by analysing monthly, bimonthly and quarterly stock market return autocorrelation . The analysis showed that all statistically significant autocorrelation coefficients are positive however only about half of them were statistically significant. However the author wants to point out that statistical significance is dependent on the length of the time period analysed but the author wants to remark that as the biggest part of the calculated autocorrelation coefficients are positive even the statistical insignificance in terms of confidence interval do not rule out the economic significance of the stock market return autocorrelation. The highest autocorrelation coefficients were found for the monthly stock market returns in the period from July 1999 till July 2000 (0.525 and standard error 0.277), bimonthly stock market returns are mostly autocorrelated in the period from May 1998 till May 2000 (0.453 and standard error 0.277) and quarterly stock market returns are mostly autocorrelated in the period from 1st quarter 1998 till 1st quarter 2001 (0.512 and standard error 0.277). We can see that the daily, monthly, bimonthly and quarterly stock market returns are autocorrelated approximately in the same time.

We can conclude from the analysis that Latvian stock market returns are not independent and it is possible to use them in the predicting the future stock market returns. However the way how to exploit this dependentness should be elaborated separately. Also there is additional research required to explain why in different

time subperiods the stock return autocorrelation is so large but in other time subperiods even negative and insignificant. Bibliography 1. Alexander S.S. Price Movements in Speculative Markets: Trends or Random Walks. Industrial Management Review II: 7-26, 1961 2. Barlett M.S. On the Theoretical Specification of Sampling Properties of Autocorrelated Time Series, Journal of the Royal Statistical Society, Series B, vol. 27, 1946, pp.27-41. 3. Cootner P.H. Stock Prices: Random vs. Systematic Changes. Industrial Management III, (Spring, 1962), 24-45 4. Cootner P.H. The Random Character of Stock Market Prices. Cambridge: M.I.T. Press, 1964 5. Courtault J.M., Kabanov Y., Bru B., Crepel P., Lebon I., Marchand A.L. Louis Bachelier on the Centenary of Theorie De La speculation. Mathematical Finance, Vol. 10, No. 3 (July 2000), 341-353 6. Gujarati N.D 1995. Basic Econometrics. McGraw-Hill, Third Edition, pp. 838 7. Fama E.F. Random Walks in Stock Market Prices. Financial Analysts Journal, September/October 1965 (reprinted January-February 1995 8. Fama E.F. The Behavior of Stock-Market Prices. Journal of Business, Volume 38, Issue 1 (Jan., 1965), 34-105 9. Kendall M.G., Hill A.B. The Analysis of Economic Time-Series-Part I: Prices. Journal of the Royal Statistical Society. Series A (General), Volume 116, Issue 1 (1953) 10. Lo A.W., MacKinlay C.A. Stock Market Prices Do not Follow Random Walks: Evidence from a Single Specification Test. The Review of Financial Studies / Spring 1988 11. Osborne M.F.M. Brownian Motion in the Stock Market. Operations Research, 10, 345-379 (1959). 12. Roberts H.V. Stock-Market Patterns and Financial Analysis: Methodological Suggestions. The Journal of Finance, Volume 14, Issue 1 (Mar., 1959), 1-10 13. Working H. A Random-Difference Series for Use in Analysis of Time Series. Journal of the American Statistical Association, Volume 29, Issue 185 (Mar., 1934), 11-24 14. http://mathworld.wolfram.com/RandomWalk.html Appendix
The formulas used in the calculation of the capitalization weighted Latvian stock market index:

It =

P
i

N ti
where

Kt
value of the index in session

It

Pt i

company i average price of the shares in session t

P
and

N Kt

i t

i in session t index divisor for non-market changes in session t

total outstanding shares of company
i t

N ti

total market capitalization of all companies included in the index in session

K t = K t 1 at _ New at _ Delisted bt ct
at _ New = 1 +

where
New t

(P
n i

N N
i t

(N
New t

Pt New
n i

)
i t

Pt

New

) [(N

i t 1

i t , Bonus

) P ]
i t

where

at _ New
N
New t New New t

index divisor adjustment factor for the case of new company inclusion in the index in session

t t t

outstanding shares of the newly included company in session

(N
N ti1
N

Pt

Pt New

share price of the newly included company in session session

total market capitalization of all newly companies included in the index in

total outstanding shares of company i in session t 1 bonus hares calculated in session t

i t , Bonus

at _ Delisted = 1

(N (P
n i

Delisted t 1 i t 1

Delisted Pt 1

i t 1

where

at _ Delisted

index divisor adjustment factor for the case of company delisting from the index in session t 1 outstanding shares of the delisted company in session t 1
Delisted total market capitalization of all from the index delisted companies in session Pt 1 t 1

N
P

Delisted t 1

(N

Delisted t 1 Delisted t 1

share price of the delisted company in session t 1

(P
n i

i t 1

N ti1

total market capitalization of all companies included in the index in session

t 1

bt = 1

[(N

D
i t 1

i t

+ N ti.Bonust Pt i + Dti

where

bt

index divisor adjustment factor for the cash dividends session

i t

total calculated dividends of company i in session

t (ex-date)

ct = ct

(N P ) (N P ) [(N N N
i t i t i t i n i t i t i t 1

i t , Bonus

) P ]
i t

where

index divisor adjustment factor for the share capital change in session t