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Market Efficiency Tests

By the definition of economics a market is efficient when the prices of commodities accurately
reflect the current information and the conditions prevailing in the market. Viewing it in terms of
the Capital Market it refers to a market in which new information is very quickly and accurately
reflected in share prices.

- For a market to be efficient it has to be large and liquid.
- Information has to be widely available in terms of accessibility and cost, and released to
investors at more or less the same time.
- Transaction costs have to be cheaper than the expected profits of an investment
strategy.
- Investors must also have enough funds to take advantage of inefficiency until, it
disappears again.
- Most importantly, an investor has to believe that she or he can outperform the market.
Here outperforming refers to the ability of an investor to take advantage of the
fluctuating prices.

There are a number of different ways for testing market efficiency. And they are listed below
1. Event study
2. Portfolio study
3. Regression
4. Run test
5. Autocorrelation Function Test
6. Variance ratio test
7. Dickey-Fuller unit root test
8. Volatility test
9. Co integration test
10. Long horizon test

Tests of market efficiency look at the weather specific investment strategies earn excess returns
or not. In every case, a test of market efficiency is a joint test of market efficiency and the
efficacy of the model used for expected returns. When there is evidence of excess returns in a
test of market efficiency, it can indicate that markets are inefficient or that the model used to
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compute expected returns is wrong or both. The following three tests are conducted to
determine whether excess return is earned or not.

Event Study
An event study is designed to examine market reactions to, and excess returns around specific
information events. The information events can be market-wide, such as macro-economic
announcements, or firm-specific, such as earnings or dividend announcements. This study
follows certain steps which are given below

Steps:
The event to be studied is clearly identified, and the date on which the event was announced
pinpointed.
Returns are collected around these dates for each of the firms in the sample. In case of
collecting the return two things must be taken into account.

-First, the analyst has to decide whether to collect weekly, daily or shorter interval
returns around the event.
-Second, the analyst has to determine how many periods of returns before and after the
announcement date will be considered as part of the 'event window'.

The returns around the announcement date, are adjusted for market performance and risk to
arrive at excess returns for each firm in the sample

The excess returns, by day, are averaged across all firms in the sample and a standard error is
computed.

Finally the question of whether the excess returns around the announcement are different from
zero is answered by estimating the t statistic for each n, by dividing the average excess return by
the standard error :

T statistic for excess return on day t = Average Excess Return / Standard Error

If the t statistics are statistically significant, the event affects returns; the sign of the excess return
determines whether the effect is positive or negative.

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Portfolio study:
In some investment strategies, firms with specific characteristics are viewed as more likely to be
undervalued, and therefore have excess returns, than firms without these characteristics. In these
cases, the strategies can be tested by creating portfolios of firms possessing these
characteristics at the beginning of a time period, and examining returns over the time period. To
ensure that these results are not colored by the idiosyncrasies of any one time period, this is
repeated for a number of periods.
Steps that are to be followed in portfolio study are as follows
The variable on which firms will be classified is defined, using the investment strategy as a guide.
The data on the variable is collected for every firm in the defined universe at the start of the
testing period, and firms are classified into portfolios based upon the magnitude of the variable.
The returns are collected for each firm in each portfolio for the testing period, and the returns
for each portfolio are computed, generally assuming that the stocks are equally weighted.
The beta of each portfolio is estimated, either by taking the average of the betas of the
individual stocks in the portfolio or by regressing the portfolio's returns against market returns
over a prior period.
The excess returns earned by each portfolio are computed, with the standard error of these
returns.
As a final test, the extreme portfolios can be matched against each other to see whether there
are statistically significant differences across these portfolios.

Regression:
To avoid some of the limitations of portfolio study another test ic conducted named regression
where the dependent variable is returns on stocks and independent variables are variables that
form the strategy.
Steps that must be followed in regression test are as follows

Identifying the dependent variable

In most of the cases dependent variable is the return made on investment. But it needs to things
to be judged and they are
The first thing is whether to use total return or excess return. In case of excess return, it must be
adjusted for market performance and risk. And the second thing is to decide the interval to be
used.

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Taking the variables that will underlie strategy

In this step one analyst has to go beyond the qualitative variables and chose quantitative
variable.

Checking the nature of the relationship

This relation may be linear or non linear

Running the regression

The regression can either be run
Across firms or markets at a point in time: this is called a cross sectional
regression.
For a market across a number of years: this is called a time series
regression.

While running the regression it must pass through some tests for statistical significance to
ensure that they are different from zero. Both t statistics and F statistics are used in this purpose

Two of the non parametric market efficiency tests are described below

Run Test:
The run test, also called Geary test, is a non-parametric test whereby the number of sequences
of consecutive positive and negative returns is tabulated and compared against its sampling
distribution under the random walk hypothesis. A run is defined as the repeated occurrence of
the same value or category of a variable. It is indexed by two parameters, which are the type of
the run and the length.

Autocorrelation Function Test:
The autocorrelation function (ACF) test is examined to identify the degree of autocorrelation in a
time series. It measures the correlation between the current and lagged observations of the time
series of stock returns, which is defined as:
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Some of the other tests are as follows

Dickey-Fuller Unit Root Test:
A unit root test tests whether a time series variable is non-stationary using an autoregressive
model. Unit root test can be seemed to be autocorrelation that the order is larger than 1. In
other words, a unit root test is a statistical test for the proposition that in an autoregressive
statistical model of a time series, the autoregressive parameter is one. Conceptually the unit root
tests are straightforward. In practice however there are a number of difficulties.

The first is unit root tests generally have nonstandard and non-normal asymptotic distributions.
The second is there distributions are functions of standard Brownian motions and do not have
convenient closed form expressions. Consequently critical values must be calculated.
The third is the distributions are affected by the inclusion of deterministic terms for example the
constant term, time trend.


Volatility Test:

In the late 1970s researchers interested in the efficiency of asset markets shifted their focus
from the predictability returns to the volatility of prices.