Mr. J believes that the market has demonstrated a weak type of efficiency. Explain the various types of tests that can be used to prove the weak…

(a) Three types of tests can be employed to empirically verify the weak form of Efficient Market Theory- Serial Correlation Test, Run Test and Filter Rule Test. (a) Serial Correlation Test: To test for randomness in stock price changes, one has to look at serial correlation. For this purpose, price change in one period has to be correlated with price change in some other period. Price changes are considered to be serially independent. Serial correlation studies employing different stocks, different time lags and different time period have been conducted to detect serial correlation but no significant serial correlation could be discovered. These studies were carried on short term trends viz. daily, weekly, fortnightly and monthly and not in long term trends in stock prices as in such cases. Stock prices tend to move upwards. (b) Run Test: Given a series of stock price changes each price change is designated + if it represents an increase and - if it represents a decrease. The resulting series may be -,+, -, -, -, +, +. A run occurs when there is no difference between the sign of two changes. When the sign of change differs, the run ends and new run begins. ++/--/---/++/ 1 2 3 4 5 6 To test a series of price change for independence, the number of runs in that series is compared with a number of runs in a purely random series of the size and in the process determines whether it is statistically different. By and large, the result of these studies strongly supports the Random Walk Model. (c) Filter Rules Test: If the price of stock increases by at least N% buy and hold it until its price decreases by at least N% from a subsequent high. When the price decreases at least N% or more, sell it. If the behaviour of stock price changes is random, filter rules should not apply in such a buy and hold strategy. By and large, studies suggest that filter rules do not out perform a single buy and hold strategy particular after considering commission on transaction.