CHAPTER-01

INTRODUCTION AND BACKGROUND

1.0 Introduction

The purpose of this chapter is to give clear understanding of the research topic. Firstly this chapter gives the background of the research. Secondly, it provides the research problem. At the end of the research problem, chapter identifies the research question. Continuously, chapter gives the objectives of the study, significance of the study, hypothesis of the study and limitation of the study. Finally, this chapter gives the out-lines of the study. In this part, organization of the research paper is provided very clearly.

1.1 Background of the study.

Stock exchange of a country is a most important in the country's economic growth. In the stock exchange, one of the most fundamental research issues is stock price efficiency. This is an important concept both in terms of an understanding of working capital market, and in their performance and contribution to the development of a country's economy.

Market efficiency championed in the efficient market hypothesis, formulated by Eugene Fama (as cited in Reem heakal) suggests that, at any given time, prices fully reflect all available information on a particular stock and/or market. That is, the market efficiency is used to explain the relationship between information and share prices in the capital market.

If a stock market is operationally efficient there is little, or no, friction in the trading process. Information on prices and volumes of past transaction is widely available and price sensitive. Information is timely accurate. Thus, information dissemination is fast and wide. Liquidity is such that it enables market participants to buy or sell quickly at a price close to the prior (last traded ) price. Also, there is price continuity, such that, price do not change much from one transaction to another unless significant new information becomes available.

If stock market is inefficient, stock prices will be predictable from past return. Through this, anyone can make excess return by finding undervalued stocks. Efficient market provides accurate signals for resource allocation as market prices represent each security's intrinsic worth. Market prices can at times deviate from the securities' free value, but these deviations are completely random and uncorrelated.

There are so many studies conducted on return predictability. This return predictability was tested on short-run basis and long-run basis. Each stock market in the world was examined on short and long-run predictability of return by different researchers using different methodologies. Those studies used the daily, weekly, and monthly returns. From the previous work, developed markets are efficient such as, United states, United kingdom, Japan, etc. The available evidence shows that, while some emerging markets are weak form efficient, others are not.

In Srilanka also, many studies were conducted on return predictability on short and long-run basis. They used daily, weekly, and monthly return for those studies. All results revealed return predictability on short-run and long-run basis provided evidence against weak form efficiency other than a single study. That examined the daily data for twenty companies for sixteen months period and found evidence consistent with the weak form efficiency.

Since the market efficiency is the most fundamental research issue, this study also analyses the weak form market efficiency of the CSE for the limited period and it will compare the results with previous research work

1.2 Research problem

The EMH implies that no group of investors should be able to consistently find undervalued or overvalued securities using a pre-selected strategy. If, say, overvalued securities can be found, then arbitrators will short them until they are ‘correctly' priced. Failing this, it is expected that all investors will be able to discover the same securities such that, if one wants to sell, the only other person willing to trade will also be selling. If a superior strategy could be found, investor will adapt it until its superiority is neutralized. Rational expectations literature suggests that there should be very little or no trading in individual stocks under these conditions. However, on a typical day millions of shares exchange hands on the CSE and on other stock exchanges around the world.

Given this appetite for trading, the billions spent on asset management and the massive arbitratory activity present today's securities markets, it will be unconvincing to say that information trading has no place in an efficient market. If the markets were sufficiently efficient to provide no profitable opportunities to information traders, then it should be expected that active money managers would not exist. Nevertheless the EMH also asserts that noise trading will not survive in an open market as long as there are arbitratory, in which case, there will be no place for both ‘noise' and informed traders. It, therefore, is reasonable to assume that there is continuous availability of profit making opportunities which sustains the operations and existence of traders, be they informed or uninformed, otherwise the robustness of the hypothesis is questionable.

The EMH has been widely accepted as valid, but evidence against market efficiency is mounting. To some, this evidence is disturbing and they raise concerns on potential sampling errors, the formative nature of behavioral theories as well as other econometric concerns. However, to other researchers, it is ‘liberating' and ‘enough' to cast doubts over the robustness of the efficient markets proposition. These researchers maintain that price adjustment to new information is a continuous process and does not occur instantaneously. The market is continuously seeking to price securities correctly, making the current price, “at best, a noisy (or incomplete) proxy of the security's true fundamental value.”

In the wake of these increased concerns over the robustness of the EMH it is important to test the efficiency of the local stock market. Therefore the research problem of this study is market efficiency of the CSE.

1.3 Research questions

Based on the research problem, the following research question is formulated.

“ Is Colombo stock exchange efficient in weak form?”

1.4 Objectives of the study

The main objective of the study is to test the weak form efficiency of the Colombo stock exchange. Through this, it will obtain the following sub objectives.

- Whether stock prices follow random walk model.

- Whether the market return is predictable on short run.

1.5 Significance of the study.

Since the making of investment decision, the regulatory standards, performance evaluation, and even corporate disclosure decisions are dependent, to some degree, on the efficiency of the market, research findings on market efficiency will be helpful to stockholders, CSE, listed companies and chartist.

Stock holders:

They can make the selling and buying decision of shares based on market efficiency

Listed companies:

Information about market efficiency leads the listed companies to decide about their financing decision in effective way.

Potential stock holders:

This paper will analyse the market efficiency of different sector's stock prices. So, it will lead the potential stock holders to make decision about investment.

Chartist:

The information against market efficiency will be helpful to chartist to predict future share price movements.

Security exchange regulatory bodies:

Results about the market efficiency of the CSE will help to the regulatory bodies in their policy making decisions to improve the market condition.

1.6 Hypothesis

The following hypotheses are formulated for the purpose of this study.

H1 : The Colombo stock exchange follows random walk model.

H2 : The Colombo stock exchange is efficient weak form

1.7 Limitations of the study

This research is limited by the following limitations:

- The market return and return of the individual companies are calculated without adjusting the dividend, bonus and right issue.

- The study does not consider the transaction cost involving in the stock market

- The time available to carry out the research is limited.

- This study utilizes relatively shorter time period.

1.8 Out lines of the study.

The lay out of this paper is as follows:

First chapter gives introduction and back round of the research. The second chapter outlines the review of literature. This chapter provides the theoretical concept of EMH and empirical works. Empirical works include research findings on this topic performed in CSE and also in another country's share market. Chapter three provides the detail explanation of the methodology. The chapter four outlines the data presentation and analysis. The last fifth chapter outlines the findings and conclusion.

Source: Essay UK - http://turkiyegoz.com/free-essays/finance/research-on-stock.php


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