An empirical test of the random walk model for the Nairobi Stock Exchange (NSE)

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 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.