AN EMPIRICAL TEST OF THE RANDOM WALK MODEL FOR THE NAIROBI STOCK EXCHANGE (NSE) BY: PEREZ A. ANYUMBA. A PROJECT SUBMITTED IN PARTIAL FULFILMENT OF REQUIREMENT FOR THE AWARD OF MASTER OF BUSINESS ADMINISTRATION (MBA) DEGREE. SCHOOL OF BUSINESS, UNIVERSITY OF NAIROBI. NOVEMBER 2010. DECLARATION I the undersigned declare that this research project is my original work and has not been submitted to any college, institution or University other than the University of Nairobi for academic purposes. Signed: _______________________ Date: ________________ PEREZ A. ANYUMBA D61/71217/2008 This research project has been submitted with my approval as University supervisor. Signed: _______________________ Date: ________________ MR. MOSES ANYANGU LECTURER, DEPT. OF FINANCE AND ACCOUNTING UNIVERSITY OF NAIROBI. DEDICATION This study has been dedicated to my dear husband Robert, my son Albert, my daughter Mical and my sister Rebecca for their love, understanding and patience when I could not be with them because of my studies. May they receive God’s blessings in abundance. ii ACKNOWLEDGEMENT First and foremost I thank God, for giving me the strength to go through this demanding and rewarding exercise. I appreciate and wish to extend my best wishes and gratitude to all whose assistance and encouragement enabled me to complete this project. Special thanks to my supervisor, Mr. Moses Anyangu for his invaluable input, dedication to this work, expert support, knowledge , motivation, patience and encouragement. God bless you. I would like to thank my family for standing by me throughout the challenge. Special thanks to my son Albert and daughter Mical for putting up with my absence. My loving husband Robert Otom and my sisters Rebecca, Miriam and Lillian for your support through the years. God bless you abundantly. To my friends Isaac and Robert Mule for your faithful academic support. God bless you. To NSE that provided me with the needed data for this project, I say thank you very much. I am grateful to my colleagues for the various information and contribution in whichever way, especially Peris Kiguta, may God bless you, not forgetting my different groups, Young Professionals (OLQP church) and Success Island members. Finally, my sincere appreciation to my late parents, I will always be grateful for your noble support in bringing me up to the person I am. God bless you. iii ABSTRACT It is usually believed that the markets in developing and less developed countries are not efficient in semi-strong form or strong form. Efficient capital market is one which prices fully reflect the available information. An important implication of efficient market theorists is that stock market should approximately follow a random walk. The Random walk Model states that present market price is the best indicator of the future market price with an error term that is stochastic in nature. Hence the next period’s price is anybody’s guess. The purpose of the study is to empirically test whether NSE indices follow random walk or not, that is to determine whether NSE conforms to the efficient market hypothesis or not. If NSE follows random walk, the share prices cannot be predicted or forecasted using predictive model developed using the historical data. Hence NSE will be classical example of efficient capital market in developing economy in the weak form. The research study assessed the variance ratio of NSE 20 share index and NASI at lag q and corresponding Z-statistic for different specification of the error Et term behavior between operational periods; 1st March 2004 to 30th April 2009 and 1st January 2008 to 30th April 2009 respectively. It adopted a model in random walk first designed by Bachelier in 1990 but modified by substituting stock prices by NSE share indices. The study population will comprise of the NSE 20 share indices points and NASI. The study used secondary data collected from NSE daily index return files, daily newspapers and internet. NSE was found to follow random walk, hence according to this project; it has been classified as efficient market in a developing economy under weak form of Market Efficiency. The information is significant to different stake holders in making informed iv decisions in relation to the share prices, better policies to regulate the players in CMA, proper planning and also form a basis of further research on the subject. v LIST OF ABBREVIATIONS AIG (EA) - American Insurance Group (East Africa) AIMS - Alternative Investment market Segment ANN - Artificial neutral network ANOVA - Analysis of Variance ARIMA - Auto-regression Integrated Moving Average ASE - American Stock Exchange ASMs - Asian stock markets BSE - Bombay stock exchange CRSP - Centre for research in security prices CSE - Chittagong Stock Exchange D/N - Daily Nation DSE - Dhaka Stock Exchange DW -Durbin Watson Test ESMs - Emerging Stock Markets FMA - Fixed length moving average GSE DSI - Ghana Stock Exchange Databank stock Index ISE - Indian stock exchange ISM - Indian stock market NASI - Nairobi Stock Exchange All Share Index NYSE - New York Stock Exchange NBK - National Bank of Kenya NSE - Nairobi stock Exchange P/E - Price per Earning Ratio SKM - South Korean market USSM - United States Stock market VMA - Variable length moving average ZSE - Zimbabwe Stock Exchange vi LIST OF TABLES Table 4.2.1: Weekly values of NSE 20 share indices for null hypothesis of Random Walk Model. Table 4.2.2: Weekly values of NASI for null hypothesis of Random Walk Model. Table 4.2.3: Monthly values of NSE 20 share indices for null hypothesis of Random walk Model. Table 4.2.4: Monthly values of NASI for null hypothesis of the Random Walk Model vii LIST OF FIGURES Figure 4.3.1: NSE 20 share weekly indices based on Monday’s reports of the first twenty weeks (1st March 2004 to 30th April 2005) Figure 4.3.2: NSE 20 share weekly indices based on Monday’s reports of the last twenty weeks (1st March 2008 to 30th April 2009) Figure 4.3.3: NSE 20 share monthly indices based on the last working day of the month for the first one year period for the study (1st March 2004 to 30th April 2005) Figure 4.3.4: NSE 20 share monthly indices based on the last working day of the month for the last one year period for the study (1st March 2008 to 30th April 2009) Figure 4.3.5: NASI monthly indices based on the last working day of the month (1st January 2008 to 30th April 2009) viii TABLE OF CONTENTS DECLARATION............................................................................................................ii DEDICATION................................................................................................................iii ACKNOWLEDGEMENT..............................................................................................iv ABSTRACT....................................................................................................................v LISTOF TABLES............................................................................................................ix LIST OF FIGURES..........................................................................................................x CHAPTER ONE: INTRODUCTION...........................................................................1 1.1 Background to the study.........................................................................................1 1.2 Statement of the Problem.......................................................................................5 1.3 Research objective..................................................................................................8 1.4 Importance of the Study........................................................................................8 CHAPTER TWO: LITERATURE REVIEW.............................................................10 2.0 Introduction............................................................................................................10 2.1 Theoritical Literature..............................................................................................10 2.1.1 The Genesis of random in stock prices................................................................10 2.1.2Theory of efficient market hypothesis..................................................................11 2.1.3 The Dumb Agent Theory.....................................................................................11 2.2 Empirical Studies....................................................................................................12 2.2.1 Empirical evidence of independence...................................................................12 2.2.1 Empirical evidence against independence...........................................................15 2.3 Common Predictive Techniques.............................................................................21 2.3.1 Chartist or technical theories...............................................................................22 2.3.2 Fundamental or intrinsic value analysis..............................................................23 2.4 Historic Information …………………………………………..……………….…24 2.4.1 New Information………………………………………………………………...24 2.5 The interaction between weak form market efficiency and the emerging markets……………………………………………………………………………..…26 2.6 Criticism of random walk…………………………………………………………27 ix 2.7 Conceptual framework……………………………………………………………28 2.8 Conclusion from Literature Review………………………………………………30 CHAPTER THREE: RESEARCH METHODOLOGY.........................................32 3.0 Introduction............................................................................................................32 3.1 Research Design.....................................................................................................32 3.2 The target population..............................................................................................32 3.3 Sample....................................................................................................................33 3.4 Data type and Collection Techniques………………………………………..……33 3.5 Data Analysis………………………………………………………………….......33 CHAPTER FOUR: DATA ANALYSIS,RESULTS AND DISCUSSION.................35 4.0 Introduction............................................................................................................35 4.1 Data Analysis..........................................................................................................35 4.2 Tables and Analysis of Results...............................................................................36 4.3 Line graphs for NSE 20 share index and NASI for portions of the study period...44 4.4 Summary of Findings.............................................................................................48 CHAPTER FIVE: CONCLUSIONS AND RECOMMENDATIONS.......................50 5.0 Introduction............................................................................................................50 5.1 Conclusions............................................................................................................50 5.2 Recommendations..................................................................................................51 5.3 Limitation of the study...........................................................................................51 54 Suggestions for Further Research............................................................................52 REFERENCES...............................................................................................................53 APPENDIX..................................................................................................................58 x