Chapter 1 Introduction The volatility of the stock market noted in several literatures had boosted the attempt to determine its source and its effects particularly predictions and future impact on trading in the stock market (Stoll and Whaley, 1990; Edwards, 1988; Harris, Sofianos, and Shapiro, 1990; Neal, 1991).[1] However, due to the inherent uncertainty (see Keynes 1965)[2] in stock market trading, scholars advocated several tests and methods in stock market forecasting. Thus, models were established by notable scholars, the most popular of which was Fama’s model (1981, 1970; Fama and French, 1988; Fama and Schwert 1977)[3] who advocated the efficient market hypothesis (EMH).
In testing the weak form of market efficiency of EMH, (Grabele, 2003; (Russel and Torbey, 2003; Fama, 1965; Cootner, 1962; Osborne, 1962)[4], random walk model was utilized since it was generally agreed upon that price changes are random and past changes were not useful in forecasting future price changes particularly after transaction costs were taken into account. While there had been contentions on this issue (Fama and French, 1988; Poterba and Summers, 1988)[5], their findings were inconclusive. Fama (1970)[6] made a distinction between three forms of EMH: the weak form, the semi-strong form, and the strong form. The weak form of the hypothesis was touted as more consistent than the other models (Russel & Torbey, 2003).[7]
The random walk model was also used to predict future prices using past data (Grabolle, 2003; Samuels, et al., 1999; Dezelan, 1999)[8] which Fama (1991)[9] expanded to predict future shocks using accounting and macroeconomic variables. This model is usually used in developed capital markets such as the United States and the United Kingdom.
Despite the strong following of the EMH and the weak form of EMH, several scholars emerged challenging the model arguing that stock prices adjust slowly to information. (Rozeff and Kinney, 1976; Banz, 1981).[10]
In his 1999 work, Fama acknowledged that the EMH is not a bullet proof description of price formation. However, there has yet to be a specific model of price formation that can replace the EMH. Following this heed, Russel and Trobey (2003)[11] proposed that the EMH paradigm be refined.
This study attempted to contribute to the literature proving that Fama’s model of weak test EMH continues to be relevant in explaining and predicting future stock market trading and prices in developed markets. Specifically, the UK market was utilized in testing this model using the FTSE 100 index.
[1] Stoll, H. R., and Whaley, R.E. (1990) Program trading and individual stock returns: Ingredients of the triple-witching brew. Journal of Business, Vol. 63, No. 1, Pt. 2, 1990, pp. s165-s192; Harris, L., Sofianos, G. and Shapiro, J. (1990) Program trading and intraday volatility. New York Stock Exchange, working paper, No. 90-03, 1990; Edwards, F. R. (1988) Does futures trading increase stock market volatility. Financial Analysts Journal January/February 1988, pp. 63-69; Neal, R. (1991) Program trading on the NYSE: A descriptive analysis and estimates of the intra-day impact on stock returns. University of Washington, working paper.
[2] Fama , E. (1965) The behavior of Stock Market Prices. Journal of Business, vol 38 , p.34-105.
[3] Fama, E. (1981). Stock Returns, Real Activity, Inflation, and Money. American Economic Review 71: 545-565, and (1970). Efficient Capital Markets: A review of theory and Empirical Work”, Journal of Finance, vol-25, no-2(May,1970), Pp.383-417; Fama, E. F., and French, K. (1988) Permanent and Temporary Components of Stock Prices. Journal of Political Economy, 96 (1988), pp. 246-273; Fama, E. F., and Schwert, G.W. (Nov 1977) Asset Returns and Inflation. Journal of Financial Economics, 5 (November 1977), pp. 115-146.
[4] Grabele, U. (2003) The Efficient market hypothesis. Business School University of Brighton. Available at [www-user.tu-chwmnitz.de]. Accessed [27/09/03]; Russel, P. S. & Torbey, V. M. (2003) The efficient market hypothesis on trial: A survey. Business Quest. Available at [www.westga.edu]. Accessed [25/09/03]; supra Fama , E. (1965); Cootner, P. (1962) Stock Prices: Random vs. Systematic Changes. Industrial Management Review, vol. 3, spring, pp.24-45; Osborne, M.F.M., (1962), Periodic Structure In the Brownian Motion in the Stock Prices. Operation Research, (May/June) ,Pp.345-379.
[5] Supra Fama and French, 1988; Poterba, J.M. and Summers, L. (1988) Mean Reversion in Stock Prices. Journal of Financial Economics, 22, pp. 27-59.
[6] Fama, E. (1970). Efficient Capital Markets: A review of theory and Empirical Work”, Journal of Finance, vol-25, no-2(May,1970), Pp.383-417.
[7] Supra, Russel and Torbey.
[8] Samuels et al. (1999) The Efficient Market Hypothesis. Financial Management & Decision Making, 187 – 208; supra Grabolle (2003); Dezelan, S. (1999) Efficiency at the Slovenian capital market. Available at [www.ef.uni-lj.si]. Accessed {27/09/03].
9 Fama, E. (1991) Efficient capital markets: II, The Journal of Finance, vol. XLVI, No. 5, December, 1575-1617.
10 Rozeff, M.S., and W.R. Kinney (1976) Capital market seasonality: The case of stock returns. Journal of Financial Economics 3, 379-402; Banz, R. (1981) The relationship between return and market value of common stocks. Journal of Financial Economics 9, 3-18.
[8] Supra, Russel and Tobbey.
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