Are There Trends Towards Market Efficiency?

A Study of the Indian Stock Market†

Ash Narayan Sah* and G Omkarnath**

The financial sector liberalization in India was initiated on the basis of the recommendations of the
Narasimham Committee on Financial System. In particular, the reform of the Indian stock market was
guided by two broad themes—structural transformation and speedy access to information. A decade of
reform has brought about a radical transformation of the Indian stock market. This study employed the
GARCH-M model to test the efficiency of the stock market in India, along with various autocorrelation
tests for different sub-samples, using the daily data on S&P CNX Nifty from January 1, 1996 to March
31, 2005. The results suggest that there are periods of efficiency in its weak form, followed by
inefficiency. The observed inefficiency, particularly after the introduction of futures and option in returns
may be due to some dynamics in higher order moments of the residuals.

Introduction
The financial sector liberalization that started in India in the early 1990s was based on
the various recommendations provided in the Narasimham Committee Report on the
Financial System, submitted in September 1992. Financial market reform was an integral
part of the financial sector reform that brought gradual improvement in the functioning
of the Indian stock market. These reforms were aimed at enhancing competition,
transparency and efficiency in the Indian financial market.
The reform in the Indian stock market brought a paradigm shift in the functioning and
structure of the market that was guided by two broad themes—structural transformation
and speedy access to information. On one hand, massive institutional reforms were
undertaken to improve the functioning of the market. This resulted in greater
participation of both individual and institutional investors. On the other hand, advances
in information technology facilitated computerization on a large scale and Internet
trading facilitated trading from any part of the country.
Few notable developments in this direction were; the permission given to the private
sector to enter into the mutual fund industry (earlier dominated by Unit Trust of India
(UTI) since 1992-93). Since September 1992 foreign institutional investors were
permitted to invest in Indian capital market and Indian companies were allowed to raise
funds abroad through GDRs and ADRs. The Indian capital market integrated more with
the world market since 1999, when Indian companies started listing on foreign stock
exchanges, especially in the Nasdaq.
Besides this, certain institutional reforms such as, the setting up of the National Stock
Exchange (NSE) and the Securities and Exchange Board of India (SEBI), introduction of
† This paper was presented at the conference jointly organized by The Icfai-Philadelphia University
in December 2005 at Hyderabad.
* Former Research Associate, The Icfai University, Andhra Pradesh, India.
E-mail: ashman24@rediffmail.com
* * Reader, University of Hyderabad, Hyderabad, Andhra Pradesh, India.
E-mail: omkarss@uohyd.ernet.in

© 2007 IUP. All Rights Reserved.

Are There Trends Towards Market Efficiency? A Study of the Indian Stock Market 71
on-line trading system by NSE for the first time in the country in June 1994 in the debt
segment and in November 1994 in the equity segment, establishment of National
Securities Clearing Corporation (NSCC) and National Depository Limited (NSDL) in
1996, abolition of badla transaction and introduction of rolling settlement of ‘T+5’ in
January, 1998 (which subsequently become ‘T+2’ to improve cash market operation) and
introduction of index futures in June, 2000 and index option in June, 2001. All these
developments have considerably changed the functioning of the Indian stock market.
A decade of reform has brought about a radical transformation of the Indian stock
market and it is considered as one of the developed markets of the world today. This study
examines the market efficiency of the leading stock index S&P CNX Nifty in the
backdrop of all the developments that have taken place in the recent years, in India.

The Concept of Efficient Markets1

The term 'efficient market' is used to describe a market in which relevant information is
impounded into the price of financial assets. If capital markets are efficient, investors
cannot expect to achieve superior profits by adopting a certain trading strategy. This is
popularly called as the ‘efficient market hypothesis’. Informational efficiency of the market
takes three forms depending upon the information reflected by securities prices. First,
Efficient Market Hypothesis (EMH) in its weak form states that all information
impounded in the past price of a stock is fully reflected in current price of the same.
Therefore, information about recent or past trends in stock prices is of no use in predicting
future price. The semi-strong form of the EMH states that current market prices reflect all
publicly available information. So, analyzing annual reports or other published data with
a view to make profit in access is not possible because market prices had already adjusted
to any good or bad news contained in such reports as soon as they were revealed. The EMH
in its strong form states that current market price reflects all—both public and private
information and even insiders would find it impossible to earn abnormal returns in the
stock market.
In one of the pioneering works by Cowles and Jones (1937), it is shown that the US
stock prices and other economic series also share these properties. Cowles (1933) found
that there was no discernable evidence of any ability to outguess the market. In a
subsequent work, Cowles (1944) provided corroborative results for a large number of
forecasts over a much longer sample period. Until 1950s, these studies however remained
largely overlooked by researchers. Thus, by 1940s, there were scattered evidence in favor
of the weak-form market efficiency and strong-form efficiency.
Since then, several studies were carried out on ‘predicting prices from past prices’,
‘forecasting returns based on variables such as dividend yield and P/E ratios’, and
‘inadequacies of current asset pricing models’.2 Another set of studies examined the
reaction of the stock market to the announcement of various events such as earnings,
stock splits, capital expenditure, divestitures, and takeovers.3 In general, event studies
confirmed that security prices seemed to adjust to new information within a day of the
event announcement—consistent with the EMH.
1
Based on Dimson and Mussavian (1998), which provides a brief history of market efficiency.
2
Fama and French, 1988; Campbell and Shiller, 1988.
3
Fama, et al. 1969.

72 The IUP Journal of Applied Finance, Vol. 13, No. 2, 2007

 However, researchers repeatedly challenged the studies based on EMH. Roll (1984), for
example, argues that most price movements for individual stocks cannot be traced to
public announcements. Cutler et al. (1989) reach similar conclusions in their analysis and
find that there is little or no correlation between the greatest aggregate market movement
and public release of important information.
In recent years, the accumulating evidence against EMH in the form of stock market
anomalies such as ‘January effect’, ‘weekend effect’, ‘small firm effect’ and P/E ratio effect
suggests that stock prices can be predicted with a fair degree of reliability. Two competing
explanations have been put forward for predictability of stock prices. According to the
proponents of EMH (Fama and French, 1995), predictability of stock prices results from
time-varying equilibrium expected returns generated by rational pricing in an efficient
market that compensates for the level of risk as predicted by Capital Asset Pricing Model
(CAPM). Critics of EMH such as La Porta et al. (1997), however, maintain that the
predictability of stock returns can be explained in terms of psychological factors, social
factors, noise trading, and fashions or ‘fads’ of irrational investors. The question about
whether predictability of returns represents rational variations in expected returns or
arises due to irrational speculative deviations from theoretical values has provided the
impetus for further inquiries about the validity of EMH. In India, several studies were
carried out; but all of them revealed mixed results.

Methodology for Testing Efficiency

Testing market efficiency in its weak form involves testing of two separate
hypotheses—successive stock prices are independent and the price changes are identically
distributed random variables. This study concentrates on testing the first hypothesis. To
establish the statistical independence of stock price, three tests are widely used—random
walk, the Sample Autocorrelation Function (SACF) and Q-statistic. However, if stock
prices are non-linear, standard tests of efficiency like autocorrelation and random walk
which are incapable of capturing non-linearity may lead to inappropriate inferences.

Random Walk
The random walk, in its simplest form represented as:
Pt  Pt 1   t
where, Pt is the price at time ‘t’ and  t is the error term which has zero mean and whose
values are independent of each other. The price changes, Pt  Pt  Pt 1 is thus simply  t
and is hence independent of past price changes and current price is the summation of all
past errors:
t
Pt    t
i 1

Thus, the random walk model implies that prices are generated by purely random
changes.
To test random walk hypothesis one of the most direct ways for an individual time
series is to check for autocorrelation.

Are There Trends Towards Market Efficiency? A Study of the Indian Stock Market 73
Serial Correlation Analysis
The independence of the stock price changes is also determined by the Sample
Autocorrelation Function (SACF) which measures the amount of linear dependence
between observations in a time series that are separated by lag k . The SACF is defined
as:
nk

 ( xt  x )( xt k  x )
 k  t1
nk


t 1
( xt  x )2

If the price changes of the stocks are independently distributed, the  k will be zero for
all time lags.

The Q-Statistic
The Q-statistic is given as:
m
Q  n ˆ k2
k 1

where, n=sample size and m=lag length. The Q statistics is use to test the joint
hypothesis that all the serial correlation for lags 1 through m are simultaneously zero
against the alternative hypothesis that at least some of them are not equal to zero. This
Q statistics in a large sample is approximately distributed as the chi-square distribution
with ‘m’ degree of freedom. If the calculated Q is greater than the critical Q value at the
chosen level of significance from the chi-square distribution, one can reject the null
hypothesis in favor of alternate hypothesis. The rejection of null hypothesis implies
dependency of the series, which violates the random walk process.

Ljung-Box (LB) Statistic

A variant of the Q statistics is the Ljung-Box (LB) statistics defined as:

 ˆ k2  m
LB  n(n  2)  
k 1  n  k 

which has better small sample properties than the Q statistics. However, in a large sample
both follow the chi-square distribution with m degree of freedom.

Non-linearity in Stock Returns

If stock prices are non-linear, standard tests of efficiency like autocorrelation and random
walk which are incapable of capturing non-linearity may lead to misleading inferences
regarding efficiency. This non-linearity in stock prices is likely to be the result of market
psychology where markets overreact to bad news and underreact to good news
(DeBondt and Thaler, 1985).
Empirically, in the presence of non-linearity, the EMH can be tested by examining the
significance of the coefficients in the following equation:

74 The IUP Journal of Applied Finance, Vol. 13, No. 2, 2007

 Rt   0  1 Rt21   2 Rt31  .....   n Rtn1   t
where, Rt is the log return. If the EMH holds, then,  0   1   2   n  0 and  t is
a white noise process.
GARCH-in Mean Model
Market efficiency can also be tested by ARCH-M or GARCH-M model. If the conditional
variance is incorporated into the mean equation, GARCH-in-Mean model can be
obtained (Engle et al. 1987). If the risk as represented by conditional variance is not
constant over time, the conditional expectation of the market returns is a linear function
of the conditional variance. The idea was to first estimate the conditional variances in
GARCH which in turn were to be used in the conditional expectations’ estimation. The
GARCH-M model is easy to interpret economically. A time dependent risk premium
implying an autocorrelation of the returns is thus a violation of efficient market
hypothesis. The GARCH-M model is specified as:
Rt   0   ht  1 Rt 1  .......   n Rt  n   t

ht   0  1 t21   2 ht 1
where, ht is the conditional variance and  t is an error term.

Findings and Discussion

Financial time series such as stock return exhibit certain statistical properties. The log
returns of NSE S&P Nifty series plotted in Figure 1 show that there are clearly defined
contiguous periods of stability and volatility, that is, volatility clustering.
The results of descriptive statistics are reported in Table 1. The mean returns of the
Indian stock markets represented by NSE Nifty were negative over the sample period. The
variability in returns of Nifty as indicated by standard deviation was 1% over the entire
period. The value of skewness is 0.27 which is different from zero indicating that the
distribution is not symmetric.

Figure 1: Log Returns (S&P Nifty)

0.15

0.10

0.05
Log Returns

0.00

–0.05

–0.10

–0.15
500 1000 1500 2000
No. of Observations

Are There Trends Towards Market Efficiency? A Study of the Indian Stock Market 75
 Besides this, the relatively large value of the Table 1: Descriptive Statistics
Kurtosis (7.79) suggests that data is leptokurtic or Mean –0.0003
heavily tailed and sharply peaked around the mean.
Median –0.0006
Jarque-Bera statistic also rejects the null of normality.
The above descriptive statistics corroborated the well Standard Deviation 0.0100
known fact that daily stock returns are not normal, Skewness 0.2700
but leptokurtic and skewed. Kurtosis 7.7900

Autocorrelation Analysis Jarque-Bera 2250.81 (0.00)

The objective of this paper is to study

whether stock returns are random walk. Table 2: Sample ACFs and PACFs
The weak form of market efficiency can for the Nifty Returns (1996-2005)
be carried out by testing whether Daily Returns
successive S&P Nifty price changes are Lags ACF PACF
independent. For T observation, the 1 0.067 0.067
Sample Autocorrelation Functions 2 –0.049 –0.053
(SACFs) and Partial Autocorrelation 3 0.022 0.209
Functions (PACFs) were estimated up
4 0.049 0.043
to 25 lags. If significant correlation is
5 0.011 0.007
found in successive stock price changes,
the series is considered as predictable 6 –0.059 –0.056
and hence the stock market is 7 –0.010 –0.003
inefficient. It should be remembered 8 0.003 –0.004
that the coefficient of the first lag in 9 0.038 0.039
the SACFs represent the coefficient of 10 0.060 0.061
the random walk model. 11 –0.030 –0.034
12 –0.034 –0.030
Nifty returns appears to have strong
autocorrelations with almost every 13 –0.001 –0.007
coefficient of the returns series being 14 0.029 0.022
outside the asymptotic bounds. 15 –0.018 –0.014
The bound is calculated as 2 which 16 –0.031 –0.015
yields to 0.041. T 17 0.014 0.012
18 –0.039 –0.051
The Ljung Box statistics Q(k) up to
25 is calculated and reported in Table 2. 19 –0.011 –0.006
The significant value of the Q statistic 20 –0.025 –0.025
at lags 1, 5, 10, 15 and 25 indicates that 21 0.021 0.030
there is evidence of autocorrelation in 22 –0.011 –0.013
the Nifty return series implying the 23 0.029 0.035
absence of market efficiency in its weak 24 0.020 0.007
form over the entire sample period. 25 –0.008 –0.005
Thus, the results fail to establish the Lags Ljung-Box Statistic P-value
hypothesis that the Indian stock market Q(1) 10.32 0.00
is efficient in its weak form over the Q(5) 22.89 0.00
entire sample period.
Q(10) 42.87 0.00
In addition to this, tests for market Q(15) 50.44 0.00
efficiency were carried out to examine Q(25) 62.84 0.00
the impact of regulatory changes such Note: The asymptotic bound for the daily returns is 0.041.
as introduction of rolling settlement.

76 The IUP Journal of Applied Finance, Vol. 13, No. 2, 2007

The results of sample ACFs and PACFs for the sub-sample of Nifty returns are reported
in Table 3A through Table 3I for each individual year from 1996 to 2005.
Table 3A shows the results for the sample period January 1996 to December 1996. It
is evident that the series does not follow random walk as the first lag is significant at 1%
level. The significant value of the Ljung-Box statistic at lags 5, 10, 15 and 25 implies that
the market was inefficient during this period. However, the results of sub-sample January
1997 to December 1997, January 1998 to December 1998, January 1999 to December 1999
and January 2000 to December 2000—reported in Table 3B through 3E—indicate that the
market was efficient in its weak form.
Table 3A: SACFs, PACFs and Ljung-Box Statistic, Sample Period: Jan. 1996–Dec. 1996
Panel A: SACFs
1 0.143 –0.019 0.077 0.159 0.126 –0.066 –0.006 0.004 0.052 –0.059
11. –0.111 –0.031 –0.109 0.037 –0.004 –0.004 –0.083 –0.031 –0.016 –0.025
20 –0.007 –0.074 0.017 –0.094 –0.064
Panel B: PACFs
1. 0.143 –0.041 0.087 0.138 0.094 –0.096 0.002 –0.039 0.040 –0.066
11. –0.075 –0.020 –0.116 0.089 0.022 0.036 –0.082 –0.007 –0.056 0.006
25. 0.004 –0.049 0.016 –0.127 –0.018
Panel C: Ljung-Box Statistic
Lags Ljung–Box Statistic P–value
Q(1) 5.18 0.02
Q(5) 17.29 0.004
Q(10) 20.05 0.029
Q(15) 29.46 0.028
Q(25) 34.64 0.095

Table 3B: SACFs, PACFs and Ljung-Box Statistic, Sample Period: Jan. 1997–Dec. 1997
Panel A: SACFs
1. 0.018 0.026 0.016 0.002 –0.074 –0.137 –0.012 –0.004 –0.039 0.060
11. –0.024 –0.124 0.084 0.082 –0.035 –0.064 0.088 –0.140 –0.013 –0.061
21. 0.060 –0.045 0.045 0.063 0.014
Panel B: PACFs
1. 0.018 0.026 0.015 0.001 –0.075 –0.135 –0.005 0.006 –0.034 0.058
11. –0.044 –0.150 0.089 0.089 –0.044 –0.062 0.067 –0.181 0.030 –0.030
21. 0.039 –0.037 0.041 –0.011 0.034
Panel C: Ljung-Box Statistic
Lags Ljung-Box Statistic P-value
Q(1) 0.078 0.78
Q(5) 1.66 0.89
Q(10) 7.69 0.65
Q(15) 15.73 0.40
Q(25) 28.33 0.29

Are There Trends Towards Market Efficiency? A Study of the Indian Stock Market 77
Table 3C: SACFs, PACFs and Ljung-Box Statistic, Sample Period: Jan. 1998-Dec. 1998
Panel A: SACFs
1. 0.027 –0.047 0.023 –0.081 0.010 0.010 –0.024 0.039 0.082 0.085
11. 0.058 0.023 –0.061 0.026 –0.004 0.041 –0.034 –0.092 –0.048 0.007
21. 0.051 –0.064 –0.128 0.020 0.018
Panel B: PACFs
1. 0.027 –0.048 0.026 –0.085 0.018 0.000 –0.019 0.034 0.081 0.087
11. 0.058 0.033 –0.049 0.040 –0.007 0.053 –0.053 –0.092 –0.073 –0.014
21. 0.034 –0.083 –0.132 0.009 0.011
Panel C: Ljung–Box Statistic
Lags Ljung-Box Statistic P-value
Q(1) 0.18 0.66
Q(5) 2.59 0.76
Q(10) 6.83 0.74
Q(15) 9.03 0.87
Q(25) 19.32 0.78

Table 3D: SACFs, PACFs and Ljung-Box Statistic, Sample Period: Jan. 1999-Dec. 1999
Panel A: SACFs
1. –0.059 –0.027 –0.005 0.058 0.033 –0.101 –0.098 –0.034 0.031 0.108
11. –0.084 0.006 0.022 –0.045 –0.029 –0.107 –0.045 –0.065 0.034 0.036
21. –0.071 0.015 0.021 –0.109 0.031
Panel B: PACFs
1. –0.059 –0.030 –0.008 0.057 0.040 –0.094 –0.109 –0.056 0.016 0.124
11. –0.049 0.002 –0.004 –0.082 –0.041 –0.089 –0.051 –0.075 0.023 0.035
21. –0.061 –0.024 –0.019 –0.143 0.008
Panel C: Ljung-Box Statistic
Lags Ljung-Box Statistic P-value
Q(1) 0.18 0.66
Q(5) 2.59 0.76
Q(10) 6.83 0.74
Q(15) 9.03 0.87
Q(25) 19.32 0.78

78 The IUP Journal of Applied Finance, Vol. 13, No. 2, 2007

Table 3E: SACFs, PACFs and Ljung-Box Statistic, Sample Period: Jan. 2000–Dec. 2000
Panel A: SACFs
1. 0.072 –0.005 –0.036 0.008 –0.078 0.007 0.018 0.051 0.038 0.027

11. –0.082 –0.070 –0.013 –0.049 0.056 0.057 0.142 –0.063 –0.143 –0.100
21. 0.022 –0.059 0.136 0.093 0.011
Panel B: PACFs
1. 0.072 –0.010 –0.035 0.013 –0.081 0.018 0.016 0.043 0.034 0.017
11. –0.082 –0.056 0.002 –0.052 0.065 0.035 0.126 –0.079 –0.139 –0.062

21. 0.039 –0.049 0.135 0.060 –0.038

Panel C: Ljung–Box Statistic

Lags Ljung–Box Statistic P–value

Q(1) 1.29 0.25

Q(5) 3.21 0.66

Q(10) 4.53 0.92

Q(15) 9.12 0.87

Q(25) 33.49 0.11

Table 3F: SACFs, PACFs and Ljung-Box Statistic, Sample Period: Jan. 2001-Dec. 2001
Panel A: SACFs
1. 0.172 –0.134 –0.050 0.048 0.123 –0.068 –0.029 –0.009 0.076 0.059
11. 0.009 –0.094 0.014 0.143 0.001 –0.008 –0.115 0.028 0.000 –0.141

21. 0.013 0.026 0.089 –0.005 –0.063

Panel B: PACFs
1. 0.172 –0.169 0.006 0.036 0.105 –0.108 0.043 –0.035 0.083 0.013
11. 0.040 –0.110 0.075 0.082 –0.035 0.036 –0.107 0.052 –0.080 –0.107
25. 0.064 0.007 0.059 –0.027 –0.023
Panel C: Ljung–Box Statistic
Lags Ljung-Box Statistic P-value

Q(1) 7.93 0.007

Q(5) 17.0 0.004
Q(10) 20.82 0.02
Q(15) 28.60 0.01
Q(25) 41.26 0.02

Are There Trends Towards Market Efficiency? A Study of the Indian Stock Market 79
Table 3G: SACFs, PACFs and Ljung–Box Statistic, Sample Period: Jan. 2002-Dec. 2002
Panel A: SACFs
1. –0.026 –0.038 0.046 0.123 0.019 0.023 –0.035 0.080 0.035 –0.122
11. –0.009 –0.015 0.038 0.031 –0.106 –0.078 0.097 0.000 –0.036 –0.023
21. 0.022 0.034 0.024 0.016 0.075
Panel B: PACFs

1. –0.026 –0.039 0.044 0.124 0.030 0.032 –0.044 0.063 0.029 –0.121
11. –0.014 –0.045 0.040 0.057 –0.091 –0.076 0.066 0.017 0.003 –0.024
21. 0.004 0.020 0.046 0.057 0.048

Panel C: Ljung-Box Statistic

Lags Ljung-Box Statistic P-value
Q(1) 0.17 0.67
Q(5) 5.03 0.41
Q(10) 11.37 0.32

Q(15) 15.08 0.44

Q(25) 22.04 0.63

Table 3H: SACFs, PACFs and Ljung-Box Statistic, Sample Period: Jan. 2003-Dec. 2003
Panel A: SACFs

1. 0.165 0.006 0.056 0.016 0.002 0.009 –0.007 –0.005 –0.019 0.002
11. 0.048 0.087 –0.004 –0.093 –0.001 –0.052 0.042 0.075 0.040 0.086
21. 0.036 0.046 0.034 0.047 –0.053
Panel B: PACFs
1. 0.165 –0.021 0.060 –0.003 0.001 0.006 –0.010 –0.002 –0.019 0.009
11. 0.047 0.076 –0.031 –0.094 0.021 –0.060 0.075 0.057 0.030 0.079
21. 0.001 0.036 –0.003 0.035 –0.066
Panel C: Ljung–Box Statistic
Lags Ljung-Box Statistic P-value
Q(1) 6.59 0.008
Q(5) 7.84 0.16
Q(10) 7.98 0.63
Q(15) 12.95 0.60
Q(25) 20.89 0.69

80 The IUP Journal of Applied Finance, Vol. 13, No. 2, 2007

 Table 3F represents the results of sub-sample over the period January 2001 to
December 2001. Here, the results show that market was not efficient. However, the results
of sub-samples—January 2002 to December 2002 and January 2003 to December
2003 (Tables 3G and 3H)—show that the market was efficient. The results of sample
period January 2004 to March 2005 (Table 3I) show that the Nifty series follow random
walk as evident from the null hypothesis of no autocorrelation at lag 1 cannot be rejected
at 10% level. However, the Ljung-Box statistic at lags 5, 10, 15 and 25 have significant
value and hence returns are predictable.

Table 3I: SACFs, PACFs and Ljung-Box Statistic, Sample Period: Jan. 2004-March 2005
Panel A: SACFs
1. 0.086 –0.225 0.059 0.142 -0.065 –0.116 –0.032 -0.061 0.011 0.148
11. -0.020 –0.112 0.065 0.123 -0.120 –0.098 –0.009 0.042 0.069 –0.012
21. 0.010 0.021 -0.001 0.071 -0.027
Panel B: PACFs
1. 0.086 –0.234 0.110 0.075 -0.058 –0.063 –0.060 –0.100 0.041 0.143
11. –0.036 –0.051 0.033 0.041 -0.097 –0.009 –0.068 0.037 0.096 –0.025
21. 0.046 –0.003 –0.057 0.076 –0.007
Panel C: Ljung-Box Statistic
Lags Ljung-Box Statistic P-value
Q(1) 2.34 0.12
Q(5) 27.35 0.00
Q(10) 40.48 0.00
Q(15) 55.93 0.00
Q(25) 63.49 0.00

Non-linearity in Returns
As mentioned earlier, if stock prices are non-linear, standard tests of efficiency like
autocorrelation and random walk which are incapable of capturing non-linearity may lead
to misleading inferences regarding efficiency. The EMH in the presence of non-linearity
is tested by the significance of the coefficients of  0 and  1 in the following equation:
Rt   0  1 Rt21   t
If the EMH holds, then,  0   1  0 and  t is a white noise process. The Wald test
was conducted to test whether the coefficient of squared returns is statistically different
from zero. The results of Wald test is reported in Table 4. The Wald test results for the
entire sample period—January 1996 to March 2005—shows that it rejects the null
hypothesis:  0 =  1 =0 implying that the market was inefficient.
The null hypothesis for the sub-sample period January 1996 to December 1996 was also
rejected at 1% level. However, the Wald test results for sub-sample January 1997 to

Are There Trends Towards Market Efficiency? A Study of the Indian Stock Market 81
 Table 4: Wald Test
Coefficients F-statistic Chi-square
Full Sample January 1996 to March 2005
0=1=0 9.91 19.82
(0.000052) (0.000050)
January 1996 to December 1996
0=1=0 22.55 45.10
(0.00) (0.00)
January 1997 to December 1997
0=1=0 0.23 0.47
(0.78) (0.78)
January 1998 to December 1998
0=1=0 1.42 2.84
(0.24) (0.24)
January 1999 to December 1999
0=1=0 3.66 7.32
(0.027) (0.025)
January 2000 to December 2000
0=1=0 6.14 12.28
(0.002) (0.002)
January 2001 to December 2001
0=1=0 9.47 18.94
(0.00) (0.00)
January 2002 to December 2002
0=1=0 0.38 0.77
(0.67) (0.67)
January 2003 to December 2003
0=1=0 3.71 7.43
(0.02) (0.02)
January 2004 to March 2005
0=1=0 32.32 64.65
(0.00) (0.00)
December 1997 and January 1998 to December 1998, show that the null hypothesis
cannot be rejected at 10% level in each case. Thus, the market was efficient
i.e., non-linearity was absent in stock returns over the period 1997 to 1998. However, the
Wald test indicates that the market was inefficient over the period 1999 to 2001 but was
efficient during January 2002 to December 2002. Again, the Wald test for sub-samples
January 2003 to December 2003 and January 2004 to March 2005 shows that the market
was inefficient as the null hypothesis was rejected at 1% level. In reject years, it seems that
the market overreacted to good and bad news.
GARCH-M Model
This study also employs GARCH-M model to test market efficiency. When the market
risk premium is too high, the volatility will also follow, leading to a false rejection of
inefficiency. To test this, GARCH-M model is estimated which incorporates time-varying
risk premium.

82 The IUP Journal of Applied Finance, Vol. 13, No. 2, 2007

 Table 5 reports the results of GARCH-M. The second column of the Table 5 gives
results for the entire sample period. The coefficients of lag returns 1 , and  3 are
significant at 1% level with t-statistics of 4.48 and 2.44 respectively. This indicates that
for the entire sample period, the Indian stock market is predictable and hence is
inefficient.
Table 5: GARCH–M Model
Coefficients Full J4–M5 J3–D3 J2–D2 J1–D1 J0–D0 J99–D99 J98–D98 J97–D97 J96–D96
Sample

0 –0.000 –0.000 0.00 0.00 0.00 –0.00 –0.00 – 0.00 –0.00 0.00
(–0.98) (–0.80) (0.42) (0.20) (0.12) (–0.37) (–0.10) (–.033) (–2.17) (0.88)
1 0.106 0.081 0.18 –0.001 0.23 0.10 0.002 0.07 0.15 0.12
(4.48) (1.12) (2.60) (–0.01) (3.12) (1.40) (0.03) (0.93) (1.62) (1.43)
2 –0.024 –0.06 –0.01 –0.04 –0.10 –0.02 –0.08 0.04 –0.01 –0.06
(–1.06) (–1.00) (–0.19) (–0.81) (–1.60) (–0.31) (–1.01) (0.56) (–0.26) (–0.76)
3 0.051 0.13 0.03 0.02 –0.002 0.01 –0.04 –0.002 0.01 0.05
(2.44) (2.36) (0.42) (0.32) (–0.04) (0.21) (–0.52) (–0.02) (0.17) (0.79)
–1.16 –0.89 –21.80 –9.38 –3.43 3.48 –7.14 4.31 21.40 –31.01
 (–0.45) (–0.14) (–0.96) (–0.23) (–0.50) (0.37) (–0.60) (0.37) (1.94) (–0.84)

The GARCH-M coefficient shows insignificant negative relationship between stock

returns and equity premium implying that the predictability of the Indian stock market
over the whole period is outside risk-return relationship and this predictability is due to
inefficient pricing rather than changes in the perception of risk premia. The CAPM does
not hold in the Indian context over the entire sample period.
The results of sub-samples January 1996 to December 1996, January 1997 to December
1997, January 1998 to December 1998, January 1999 to December 1999 and January 2000
to December 2000 show that the coefficients of lag returns , and  are not significant
at 5% level implying unpredictability of the Indian stock market. The relationship
between equity premium and stock returns is positive and significant only for the
sub-sample January 1997 to December 1997. This relationship between risk premium and
returns remains positive for the sub-sample January 1998 to December 1998 but the
coefficient is insignificant.
The results of sub-sample January 2001 to December 2001, January 2002 to December
2002 and January 2004 to March 2005 show that the coefficients of lag returns  are
significant at 5% level implying predictability of the Indian stock market and therefore
is time-dependent. The relationship between stock returns and risk premium is negative
and insignificant, implying predictability due to inefficient pricing rather than changes in
the perception of risk premia.
Both autocorrelation analysis and GARCH-M (1, 1) models show that most of the
sub-samples indicate that the market was inefficient in its weak form. The causes of
observed inefficiency of the market may be the result of dynamics of higher order
moments. To examine this, the BDS test was conducted to detect non-linear dependences
in the data.
BDS Test
BDS test was done for two sub-samples—market efficiency before and after the
introduction of futures and option trading keeping in mind that derivatives trading
improves the market quality.

Are There Trends Towards Market Efficiency? A Study of the Indian Stock Market 83
 It is a known fact that financial data often possess time varying volatilities
characterized by GARCH and its variants. BDS would be an appropriate test for testing
the null of no autocorrelation in returns of higher order. Under BDS test, in principle no
distributional assumptions are made about the data under the null hypothesis other than
that it is independent identically distributed (i.i.d) and can be interpreted as a test for
nonlinearity.
In the first step, the ARCH (1) is fitted to the data, thus eliminating non-linearity
of order two from the data. In the second step, BDS test is applied by running it on the
residuals of the ARCH (1) model so that any dependence found in the residuals must be
non-linear in nature of higher order.
This test for independence is based on estimation of correlation integrals at various
dimensions. BDS statistic estimation is non-parametric, which asymptotically follows a
normal distribution.
Tm ( )
BDS  n  m  1
Vm ( )
where n is the total number of observations, Tm(Cm(C1(, Cm( and C1( are
the correlation integrals, Vm( is the standard error of Tm( and and m are the distance
and dimension respectively, whose values are chosen by the investigator. In most of the
cases the values of  used are 0.5 and the value of m is fixed in line with the number of
observations; for example using only 5  m if 500  n .
S&P Nifty returns are filtered for linear dependence using ARCH (1). To study
whether the higher order dependence structure can be sufficiently accounted by ARCH
(1), ARCH (1) standardized residuals are then tested for independently identically
distributed (i.i.d) using BDS test. If the null hypothesis of i.i.d. is rejected by the BDS test,
we then suspect that observed inefficiency in returns may be due to some dynamics in
higher order (greater than second) moments of the residuals. Towards this end, this study
tested for autocorrelation of ˆt3 and ˆt4 by Ljung-Box statistic to detect 3rd and 4th order
dependences in the residual series.
The results of BDS test is reported in Table 6. The first column of the table provides
the values of the distance, , measured in terms of half (0.5). The second column gives
present number of embedding dimensions, m and the value of test statistics are given in
the 3rd column of Table 6. The BDS test results show that for  = s.d of linear filtered
data with m = 3, 4 and 5 the null of i.i.d was rejected for the period after the introduction
of futures and option trading that indicates that the inefficiency observed in returns may
be due to some dynamics in higher
Table 6: BDS Test
order moments of the residuals.
  After Futures Trading After Option Trading
Autocorrelation analysis of the m BDS Statistic m BDS Statistic
residual of 3rd and 4th degree by the 0.5 2 0.076 2 0.206
help of the Ljung-Box statistic is 0.5 3 2.56* 3 1.91*
reported in Table 7. The results 0.5 4 3.24* 4 2.28*
show that the null hypothesis of no 0.5 5 4.10* 5 3.25*
autocorrelation can be rejected at Note: * Indicates significance at 1% level.

84 The IUP Journal of Applied Finance, Vol. 13, No. 2, 2007

 Table 7: SACFs and PACFs of Residual of Third and Fourth Degree
After Futures Trading After Option Trading
Cubic ARCH (1) Fourth-Degree Cubic ARCH (1) Fourth-Degree
Residuals ARCH(1) Residuals Residuals ARCH(1) Residuals
Lags ACFs PACFs ACFs PACFs ACFs PACFs ACFs PACFs
1 0.040 0.040 0.015 0.015 0.066 0.066 0.033 0.033
2 0.004 0.003 0.008 0.008 0.009 0.004 0.008 0.007
3 0.030 0.030 0.015 0.015 0.039 0.038 0.019 0.019
4 0.011 0.009 –0.002 –0.002 0.008 0.003 –0.002 –0.003
5 0.047 0.046 0.019 0.019 0.044 0.043 0.022 0.022
6 –0.022 –0.027 0.001 0.001 –0.024 –0.032 0.002 0.001
7 0.001 0.002 0.000 0.000 0.015 0.018 0.001 0.000
8 –0.013 –0.016 –0.003 –0.004 –0.009 –0.015 –0.004 –0.005
9 0.009 0.010 –0.002 –0.001 0.011 0.014 0.001 0.001
10 0.134 0.132 0.091 0.091 0.148 0.145 0.102 0.102
11 –0.010 –0.017 –0.005 –0.007 –0.004 –0.020 –0.005 –0.012
12 –0.014 –0.015 –0.004 –0.005 –0.014 –0.016 –0.004 –0.005
13 0.107 0.103 0.069 0.067 0.117 0.114 0.075 0.073
14 0.025 0.014 0.002 0.001 0.023 0.006 0.003 –0.001
15 –0.006 –0.020 –0.004 –0.009 –0.008 –0.022 –0.004 –0.010
16 –0.021 –0.018 –0.002 –0.004 –0.021 –0.017 –0.002 –0.004
17 –0.010 –0.011 –0.004 –0.003 –0.010 –0.013 –0.003 –0.002
18 0.004 –0.001 –0.004 –0.005 0.001 –0.003 –0.005 –0.007
19 0.000 0.002 –0.003 –0.003 –0.006 –0.002 –0.004 –0.004
20 0.014 –0.002 0.003 –0.005 0.014 –0.008 0.003 –0.007
21 –0.006 0.002 –0.003 –0.001 –0.002 0.006 –0.005 –0.002
22 –0.023 –0.020 –0.001 0.001 –0.019 –0.016 –0.001 0.000
23 0.018 –0.011 0.002 –0.010 0.021 –0.012 0.004 –0.011
24 –0.005 –0.009 –0.003 –0.002 –0.008 –0.010 –0.004 –0.002
25 –0.002 0.006 –0.004 –0.002 0.000 0.011 –0.005 –0.002
Lags Q–Stat P–value Q–Stat P–value Q–Stat P–value Q–Stat P–value
Q(1) 0.04 0.16 0.01 0.60 0.06 0.04 0.03 0.30
Q(5) 0.04 0.32 0.01 0.95 0.04 0.18 0.02 0.85
Q(10) 0.13 0.002 0.091 0.35 0.14 0.001 0.10 0.28
Q(15) –0.006 0.00 –0.004 0.32 –0.008 0.00 0.003 0.60
Q(25) –0.002 0.008 –0.004 0.88 0.00 0.007 –0.005 0.85
lag 10 through lag 25, at 1% level for cubic residuals for the period after the introduction
of futures trading. However, fourth degree residuals are not autocorrelated.
For the period after the introduction of option trading, the Ljung-Box test of
autocorrelation of 3rd and 4th degree residuals shows very similar results to that of the
period after the introduction of futures trading. The null of no autocorrelation can be

Are There Trends Towards Market Efficiency? A Study of the Indian Stock Market 85
rejected at lag 1, 10, 15, 20 and 25 at 1% level for cubic residuals. The Ljung-Box statistic
for 4th degree residuals shows that the null hypothesis of no autocorrelation cannot be
rejected at lags 1, 5, 10, 15 and 25 at 10% level of significance implying no fourth degree
autocorrelation in the residuals of S&P returns for the period after the introduction of
option trading.

Conclusion
The study concludes that there is clear tendency towards market efficiency in the Indian
context. Though the market is not efficient over the entire sample period, the results of
sub-samples show that the market was efficient over certain sub-samples. Second,
inefficiency is due to non-linearity in returns and, higher order of non-linearity cannot
be ruled out. Third, The GARCH-M coefficient shows insignificant negative relationship
between stock returns and risk premium implying predictability, and this predictability is
due to inefficient pricing rather than changes in the perception of risk premia. The CAPM
does not hold in the Indian context. In short, there are periods of efficiency in its weak
form followed by inefficiency. Thus, there are traces of tendency towards market efficiency
in the Indian stock markets due to a radical reform undertaken in the last decade. The
observed inefficiency after the introduction of futures and option in returns may be due
to some dynamics in higher order moments of the residuals.

Reference # 01J-2007-02-05-01

References
1. Campbell J Y and Shiller R J (1988), “Stock Prices, Earnings and Expected
Dividends”, Journal of Finance, Vol. 43, pp. 661-676.

2. Cowles A (1933), “Can Stock Market Forecasters Forecast?”, Econometrica, Vol. 1,

pp. 309-324.

3. Cowles A (1944), “Stock Market Forecasting”, Econometrica, Vol. 12, pp. 206-214.

4. Cowles A and Jones H (1937), “Some A Posteriori Probabilities in Stock Market

Action”, Econometrica, Vol. 5, pp. 280-294.

5. Cutler D M, Poterba M and Summers L H (1989), “What Moves Stock Prices”, Journal
of Portfolio Management, Vol. 15, pp. 4-12.

6. De Bondt W F M and Thaler R H (1985), “Does the Stock Market Overreact?”,

Journal of Finance, Vol. 40, pp. 793-805.

7. Dimson E and Mussavian M (1998), “A Brief History of Market Efficiency”, European

Financial Management, Vol. 4, pp. 91-103.

86 The IUP Journal of Applied Finance, Vol. 13, No. 2, 2007

 8. Engle R, Lillien D and Robbins R (1987), “Estimating Time-Varying Risk Premia in
the Term Structure: The ARCH-M Model”, Econometrica, Vol. 55.
9. Fama E and French K (1988), “Dividend Yields and Expected Stock Returns”, Journal
of Financial Economics, Vol. 22, pp. 3-25.
10. Fama E and French K (1995), “Size and Book-to-market Factors in Earnings and
Returns”, Journal of Finance, Vol. 50, pp. 131-155.
11. Fama E, Fisher L, Jensen M and Roll R (1969), “The Adjustment of Stock Prices to
New Information”, International Economic Review, Vol. 10, pp. 1-21.
12. La Porta R, Lakonishok J, Shliefer A and Vishny R (1997), “Good News for Value
Stocks: Further Evidence on Market Efficiency”, Journal of Finance, Vol. 52,
pp. 859-874.
13. Roll R (1984), “Orange Juice and Weather”, American Economic Review, Vol. 74,
pp. 861-880.

Are There Trends Towards Market Efficiency? A Study of the Indian Stock Market 87