European Journal of Economics, Finance and Administrative Sciences

ISSN 1450-2275 Issue 12 (2008)

© EuroJournals, Inc. 2008
http://www.eurojournalsn.com

Efficiency in Emerging Markets - Evidence from the Emirates

Securities Market

Hazem Marashdeh
Securities and Commodities Authority, Abu Dhabi, UAE
Tel: +971505098100; Fax: +97126274600
E-mail: hazem@sca.ae

Min B. Shrestha
The South East Asian Central Banks (SEACEN) Research and Training Centre
Kuala Lumpur, Malaysia
E-mail: minshrestha@seacen.org

Abstract
This paper investigates whether the stock price index in the United Arab Emirates
Securities Market meets the criterion of weak-form market efficiency. Beside the
conventional unit root tests, the study applies Perron (1997) models to test for a unit root in
the presence of one endogenously determined structural break. The test results show that
the Emirates Securities Market data contains unit root and follow a random walk, which
suggests that the market meets the criterion of weak-form market efficiency.

Keywords: Stock Market, Market Efficiency, Unit Root, Structural Break

JEL Classification Codes: C12, D53, G12, G14

1. Introduction
The analysis of the efficient market hypothesis has attracted a great deal of interest in recent time. The
efficient market hypothesis is based on the assumption that at any given time, prices of stocks fully
reflect all the available information related to them. According to this, a stock market is seen as more
efficient if market relevant information is incorporated into assets prices. Under fully efficient markets,
past information should not affect returns in present period. In other words, the “efficient stock markets
do not allow investors to earn more above-average returns without accepting above-average risks”
(Malkiel 2003, p. 60). It is believed to be an application of rational expectation theory to the pricing of
stocks.
A very important issue to be highlighted at this stage is that market efficiency does not mean
that the market price of a stock should equal the true value of the stock. What it means is that errors in
the market price, i.e. over or under valued of the true value, should be unbiased and randomly deviated.
Based on this argument, the existence of random deviation prevents investors from finding those over
or under valued stocks.
An important implication of the efficient market hypothesis (EMH) is that stock prices should
follow a random walk, where the future price changes should be - for all practical purposes - random
and therefore unpredictable (Mishkin, 1998, p. 173). A consequence of this is that stock market return
can not be predicted from previous price changes. The random walk hypothesis is associated with the
144 European Journal of Economics, Finance And Administrative Sciences - Issue 12 (2008)

weak form of the efficient market hypothesis. This asserts that all the information contained in the
history of yesterday’s stock prices are reflected in today’s stock prices.
The main objective of this paper is to test the random walk hypothesis on Emirates securities
market. For this purpose, the study will apply two approaches. The first approach is the conventional
unit root tests such as Augmented Dickey Fuller (ADF) and Phillips-Perron (PP) tests. The second
approach is Perron (1997) which tests the unit root hypothesis in the presence of unknown structural
break. Although the subject of random walk hypothesis has been studied before, to the extent of our
knowledge no previous study has conducted unit root tests in the presence of structural change to
examine the random walk hypothesis in the Emirates Securities Market.
This paper is organized as follows. Section 2 presents the literature review on efficient market
hypothesis in the context of stock markets. An overview of the Emirates stock market is presented in
Section 3. Section 4 outlines the data and methodology used in this study. Section 5 presents the test
statistics and interprets the empirical results. Finally, Section 6 provides conclusion of the study.

2. Literature Review
While most of the empirical studies on testing the EMH focus on developed stock markets in different
parts of the world, especially US, Europe and Japan, just a few studies shed light on emerging stock
market especially stock markets in the Middle East region. One of the earliest studies that focused on
the Middle East market was done by Butler and Malaikah (1992). They examined the behavior of
individual stock returns in two stock markets, Saudi Arabia and Kuwait, over the period 1985-1989.
They used serial correlation method and run several tests to evaluate the weak form of efficiency in
these stock markets. The study tried to investigate the similarities and dissimilarities of these markets
regarding exchange mechanisms and efficiency. They concluded that institutional factors contribute to
operational inefficiency in Saudi Arabia stock market and less pronounced but significant
autocorrelations is found in many Kuwaiti stocks similar to other thinly traded markets.
A study by Al-Loughani (1995) used different statistical techniques on the Kuwait stock market
index, it concluded that this index does not follow random walk as it shows signs of stationarity.
Another study by Abraham et al. (2002) tested the random walk hypothesis (RWH) and market
efficiency hypothesis for three Gulf countries, namely Saudi Arabia, Kuwait and Bahrain. Their results
could not reject the RWH for Saudi and Bahraini markets, while the Kuwaiti market fails to follow a
random walk, which means it is inefficient.
Squalli (2005) tested for market efficiency in the selected sectors of the Dubai Financial Market
(DFM) and Abu Dhabi Securities Exchange (ADX) in United Arab Emirates (UAE) using daily
sectoral indices between 2000 and 2005. The study which was conducted using the Variance Ratio
tests rejected the random walk hypothesis in all sectors of the UAE financial markets except in the
banking sector of the DFM. The study also conducted the Runs tests and the results of this test showed
that insurance sector in the ADX to be the only weak-form efficient sector.
A recent study by Lagoarde-Segot and Lucey (2008) investigated the efficiency in relation to its
theoretical underpinning in a set of seven emerging Middle-Easter North African (MENA) stock
markets, namely, Egypt, Morocco, Tunisia, Jordan, Lebanon, Israel and Turkey. The study analyzed
the impact of market development, corporate governance and economic liberalization on the extent of
weak-form efficacy. The results suggested that the extent of weak-form efficiency in the MENA stock
markets is primarily explained by differences in stock market size. Corporate governance is factors also
have explanatory power, where as the role of economic liberalization does not appear significant.
Some of previous studies have used unit root tests in the presence of structural change to
examine the random walk hypothesis. Chaudhuri and Wu (2003) employed the Zivot and Andrews
(1992) endogenous one structural break test to examine the random walk hypothesis in seventeen
emerging markets. They found that for ten markets, the null hypothesis of a random walk can be
rejected at 1 per cent and 5 per cent significance level.
145 European Journal of Economics, Finance And Administrative Sciences - Issue 12 (2008)

Narayan and Smyth (2004) implemented the Zivot and Andrews (1992) endogenous one
structural break test and Lumsdaine Papell (1997) two structural breaks unit root test models to
examine the random walk hypothesis for stock prices in South Korea. Their results indicate that stock
prices in South Korea are characterized by a unit root, which is consistent with the random walk
hypothesis.
Chancharat and Valadkhani (2007) examine the random walk hypothesis and structural breaks
for 16 countries, mostly with developed markets, using Zivot and Andrews (ZA) and Lumsdaine and
Papell (LP) models. The ZA test results provide evidence in favor of random walk hypothesis in 14
countries. However, the LP test results show that the hypothesis is rejected for 5 countries.

3. An Overview of the Emirates Securities Market

There are two financial markets in the UAE: Abu Dhabi Securities Exchange (ADX) and Dubai
Financial Market (DFM). Both markets were established in the year 2000. The Emirates Securities
Market is electronically linked with the previous two markets, established by the Securities and
Commodities Authority. It has its own index which covers the trading on stocks for all listed
companies in both markets. The index is called The Emirates Securities Market Index. The number of
listed companies in the market in 2007 stood at 120 containing 66 companies of ADX and 54
companies of DFM.
The Emirates Securities Market has witnessed several improvements in its main indicators over
the last seven years. It serves as a good example of newly emerging stock market with significant
growth potential. Table 1 shows the main market development statistics during the period 2001-2007.

Table 1: The Emirates Securities Market Development Statistics

Market Market Listed

Price Volume Traded Value Traded Number of
Year Capitalization Capitalization Compan
Index (Share) (Million Dirham) Transactions
(Million Dirham) to GDP ratio ies
2001 1116.7 50,131 19.8 77,253,923 1,515 19,334 27
2002 1253.4 109,784 40.2 209,230,202 3,861 36,341 37
2003 1657.2 145,632 45.3 561,439,842 7,458 50,712 44
2004 3251.6 305,803 79.1 6,069,276,451 66,787 299,280 53
2005 6,840.0 839,683 172.9 33,811,933,303 509,868 2,300,452 89
2006 4,031.0 514,698 85.9 50,939,871,239 418,149 3,138,749 106
2007 6,016.2 824,629 118.1 157,318,141,814 554,334 3,354,617 120
Source: Securities and Commodities Authority, Abu Dhabi, UAE

The Emirates stock price index has increased sharply from 1116.7 in 2001 to 6016.2 in 2007
registering an annual average increase of about 43 per cent. The volume of market capitalization has
recorded a 16 fold increase in six years time while the market capitalization to GDP ratio increased
from 19.8 per cent in 2001 to 118.1 per cent in 2007. The traded value has surged up more than 300
times in the same period while the number of listed companies has grown rapidly from 27 companies
in 2001 to 120 companies in 2007.
Figure 1 shows the daily movement in the Emirates stock price index between 31 August 2003
and 13 April 2008. It can be seen from the figure that the stock price index saw a slow growth until
November 2004, increased sharply between December 2004 and November 2005, declined sharply
between December 2005 and July 2006, remained stagnant between August 2006 and September 2007,
and started to pick up after October 2007. Figure 2 shows that the stock prices highly fluctuated
between March 2005 and May 2006 and between August 2007 and February 2008 periods.
146 European Journal of Economics, Finance And Administrative Sciences - Issue 12 (2008)
Figure 1: The Emirates Stock Market Index

8, 00 0

7, 00 0

6, 00 0

5, 00 0
In d ex

4, 00 0

3, 00 0

2, 00 0

1, 00 0

0
3 1/0 8/2 003

2 9/02/ 20 04

31 /0 5/2 004

3 0/1 1/2 004

3 1/05/ 20 05

31 /0 8/2 005

2 8/0 2/2 006

3 1/08/ 20 06

30 /1 1/2 006

3 1/0 5/2 007

3 0/11/ 20 07

29 /0 2/2 008
30 /11 /2 003

31/08 /20 04

28 /02 /2 005

30 /11 /20 05

31 /05 /2 006

28/02 /20 07

31 /08 /2 007
D ate

Data Source: Securities and Commodities Authority Abu Dhabi, UAE

Figure 2: The First Difference of Emirates Stock Market Index

500.00

400.00

300.00

200.00

100.00
Index

0.00
01/09/2003

01/12/2003

01/03/2004

01/06/2004

01/09/2004

01/12/2004

01/03/2005

01/06/2005

01/09/2005

01/12/2005

01/03/2006

01/06/2006

01/09/2006

01/12/2006

01/03/2007

01/06/2007

01/09/2007

01/12/2007
-100.00 01/03/2008

-200.00

-300.00

-400.00

-500.00

D ate

Data Source: Securities and Commodities Authority Abu Dhabi, UAE

4. Data and Methodology

4.1. Description of the Data
This study employs daily stock market index data over the period 31 August 2003 to 13 April 2008.
The data are obtained from Securities and Commodities Authority (http://www.sca.ae) for a total of
1298 daily observations. The stock price index is based on the stock price value in local currency.
147 European Journal of Economics, Finance And Administrative Sciences - Issue 12 (2008)

4.2 The Conventional Unit Root Tests

To test for efficient market hypothesis in the Emirates Securities Market, the study starts with the
conventional unit root tests, namely the Augmented Dickey-Fuller (Dickey and Fuller 1979) and
Phillips-Perron (Philips and Peron 1988) tests.
The Augmented Dickey-Fuller (ADF) test has following models:
k
ΔS t = α 1 + α 2 t + β S t −1 + δ ∑ ΔS t −i +ε t (1)
i =1
k
ΔS t = α 1 + β S t −1 + δ ∑ ΔS t −i +ε t (2)
i =1
k
ΔS t = β S t −1 + δ ∑ ΔS t −i +ε t (3)
i =1

where S t is the stock price index at time t . The first model (equation 1) includes a constant term ( α1 ),
a trend term ( α 2t ), k denotes the number of lagged terms and ε t is a white noise disturbance term.
The second model (equation 2) includes a constant term only, and the third model (equation 3) does not
include intercept and trend terms. The null hypothesis of stationarity for all specifications is β = 0 .
m
The autoregressive term ( δ ∑ ΔS t −i ) is included to ensure the residual ( ε t ) is serially uncorrelated.
i =1
The Philips-Perron (PP) test introduces a non parametric method to overcome the problem of
serial correlation in the error term. In most cases the PP tests gives similar results as the ADF test. The
PP test has following specification:
Δst = α + ρst −1 + u t (4)
Equation (4) is estimated by using the ordinary least square (OLS) method.

4.3. Testing for Unit Root in the Presence of Structural Break

Perron (1989) argued that the conventional ADF and PP unit root tests are biased towards the non-
rejection of the unit root null hypothesis in the presence of structural breaks. These tests lack power in
the presence of structural breaks in the series and they may fail to show whether a series is first
difference stationary (Wilson et. al. 2003, p.445). Perron (1989) perceived this phenomenon and
proposes a unit root test that allows for a structural change at a known date by incorporating dummy
variables for the structural change into ADF test. Subsequent works based on Perron (1989) have
developed models that allow a structural change at an unknown date in which the choice of the break
point is determined endogenously (see Zivot and Andrews 1992, Banerjee et al 1992, Perron and
Vogelsang 1992, and Perron 1997). This approach is preferred because any arbitrarily fixed date can be
subject to criticism of data mining (Lai 2004).
This study uses Perron (1997) procedure as it is the most comprehensive one compared to all
other models. Perron (1997) statistical procedure includes both Innovational Outlier models, namely
IO1 and IO2 and the Additive Outlier model (AO). These models test for a unit root allowing for the
presence of structural change in the trend function occurred at most once. These tests are considered to
be more robust and powerful than the conventional unit root tests.
In the IO models, the change is assumed to occur gradually while in the AO model, the change
is assumed to occur instantaneously. Among the two IO models, IO1 allows for the occurrence of
gradual change in the intercept of the trend function. It has the following representation:
k
s t = μ + β t + θDU t + δDTb + αst −1 + ∑ ci Δst −1 + e (5)
i −1

where DU t = 1 if t > Tb , 0 otherwise.

DTb = 1 , t = Tb + 1 0 otherwise.
148 European Journal of Economics, Finance And Administrative Sciences - Issue 12 (2008)

IO2 model is the most inclusive model as it allows for the occurrence of changes in both the
intercept and the slope of the trend function. The null hypothesis α = 1 is tested using the t-statistic.
The IO2 model is as follows:
k
s t = μ + β t + θDU t + γDTt + δDTb + αst −1 + ∑ ci Δst −1 + e (6)
i −1
where = 1(t) if, 0 otherwise.
The third model is an Additive Outlier model (AO) that allows for a sudden and rapid change to
the trend function. This model uses a two-step procedure. First, the series is de-trended as follows:
st = μ + βt + γDTt * + ~
st (7)
where DTt* = 1(t − Tb ) if t > Tb , 0 otherwise.
The test is then performed using the t-statistic for α = 1 in the regression:
k
~
st = α~
st −1 + ∑ ci Δ~
s t − i + et (8)
i =1
The selection of the order of lag employs the “general-to-specific” procedure based on the
significant t-statistic of the coefficient associated with the last included lag in the estimated regression.
To determine the time of the break point endogenously at an unknown break point, the time of the
break Tb is selected as the value that minimizes the t-statistic for testing. α = 1

5. Empirical Test Results

The results of the ADF and PP tests conducted at levels and at first difference are given in tables 2 and
3. The results reported in Table 2 show that both the ADF and the PP fail to reject the null hypothesis
of a unit root in the daily Emirates stock price index at levels. The results in Table 3 indicate that the t-
statistics for both the ADF and the PP models are greater than their respective critical values for the
stock price index at first difference. This suggests that the unit root hypothesis is rejected. From these
results, it can be inferred that the Emirates stock price index is non-stationary and becomes stationary
at first difference, in other words, they follow a random walk.

Table 2: ADF and PP Unit Root Test Results at Levels

Null Hypothesis: INDEX has a unit root

Test Type t-Statistics Critical Value 1% Critical Value 5% Inference
Augmented Dickey Fuller (ADF) -1.0454 -3.9652 -3.4133 Do not reject
Phillips-Perron(PP) -1.2519 -3.9651 -3.4132 Do not reject

Table 3: ADF and PP Unit Root Test Results at First Difference

Null Hypothesis: INDEX at first difference has a unit root

Test Type t-Statistics Critical Value 1% Critical Value 5% Inference
Augmented Dickey Fuller (ADF) -26.2445 -3.9652 -3.4133 Reject
Phillips-Perron(PP) -28.6171 -3.9651 -3.4132 Reject

The test results of Perron (1997) models are presented in Table 4. The statistics for Tα for all
the three models, namely, IO2, IO1 and AO are below the critical values in absolute terms at 1 per cent
significance level. These results show that all the three models of Perron (1997) find unit root in the
Emirates stock price index. Both the Innovational Outliers models (IO1 and IO2) suggest that there
exist a structural break in Emirates stock price index on 22 January 2006 while Additive Outlier model
(AO) indicates a structural break on 01 June 2005. It is not surprising that both structural breaks in the
Emirates stock price index occurred during a period of an exceptional price increases (the year 2005)
and a period of a price correction (the year 2006).
149 European Journal of Economics, Finance And Administrative Sciences - Issue 12 (2008)
Table 4: Perron (1997) Unit Root Test Results

Break Date
Model k β Ө γ δ T∞ = 1 Inference
(Tb)
Innovational Outlier 0.0884 -12.6948 -0.0429 68.6835
22/01/2006 6 -3.3399 Unit root
Model – IO2 (3.3060) (1.0624) (-1.4248) (1.0624)
Innovational Outlier 0.0560 -37.5536 66.4181
22/01/2006 6 n.a. -3.4507 Unit root
Model – IO1 (3.9876) (-4.2527) (1.0273)
Additive Outlier 10.4829 -11.6721
01/06/2005 6 n.a. n.a. -1.7598 Unit root
Model – AO (51.2446) (-39.4814)
Critical values for T∞ = 1: 1% 5% 10%
IO2 -5.57 -5.08 -4.82
IO1 -5.41 -4.80 -4.58
AO -4.91 -4.36 -4.07
Figures in brackets are Student t-Statistics

6. Conclusion
This paper examines the efficient market hypothesis in Emirates stock market employing conventional
Augmented Dickey Fuller and Philip-Perron tests along with Perron’s Innovational Outlier and
Additive Outlier models which allow an endogenously determined structural break in data. All these
models show that the Emirates stock market index has a unit root and follows a random walk. This is
consistent with the weak-form of the efficient market hypothesis suggesting that past movements in
stock prices cannot be used to predict their future movements. The presence of random walk in the
stock price data has important implications for issuers of equity and portfolio investors. The efficiency
in the stock market can attract foreign portfolio investment; encourage the domestic savings and
improving the pricing and availability of capital. This has important implications for the allocation of
capital within an economy and hence overall economic development.
150 European Journal of Economics, Finance And Administrative Sciences - Issue 12 (2008)

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