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MRN
31,2
Random walk, capital market
efficiency and predicting stock
returns for Hong Kong Exchanges
142 and Clearing Limited
Jeffrey E. Jarrett
University of Rhode Island, Ballentine Hall/Management Science, Kingston,
Rhode Island, USA
Abstract
Purpose – This paper seeks to study capital market efficiency, because results may infer that there
are predictable properties of the time series of prices of traded securities on organized markets in
Hong Kong, the third largest exchange in the Pacific-Basin of Asia.
Design/methodology/approach – The weak form of the efficient markets hypothesis is examined
to indicate its usefulness in terms of the results of this study. Do the data indicate that the times series
of closing prices is a random walk or are their predictable properties?
Findings – It will be noted from the results that the model identifies predictive short-term properties
that exist in the data of returns of Hong Kong Exchanges for the period studied.
Research/limitations/implications – Conclusions are limited to those firms studied and the time
period covered.
Originality/value – For the securities exchanges in Hong Kong, evidence indicates that the weak
form of the efficient markets hypothesis does not characterize the trading market.
Keywords Capital markets, Predictive process, Variational techniques
Paper type Research paper

Introduction
The purpose of this paper is to clarify the existence of time series characteristics of
daily stock prices of securities marketed on the Hong Kong exchanges and clearing
limited (HKEx, hereafter referred to as the Hong Kong stock exchange). This study
does not focus on index numbers of daily stock market prices but rather on the returns
of traded securities because we wish to study capital market efficiency. Furthermore,
this study is important because of the theory of market efficiency and its application to
short-term forecasting of closing prices of traded securities for the Hong Kong stock
exchange. In this study, we follow the arguments presented in Jarrett and Kyper
(2005a), but with data for an Asian exchange, that is, HKEx.
The important issue is the empirical analysis of financial time series to determine if
returns on risky assets are serially independent. This is a requirement of the efficient
market hypothesis in its weak form; that is, the current stock prices fully reflect all the
past stock price information. A precise formulation of an empirically refutable efficient
market hypothesis must be model specific. Historically the majority of such tests
focused on the predictability of common stock returns. Hence, we classify most studies

Management Research News

Vol. 31 No. 2, 2008
pp. 142-148
# Emerald Group Publishing Limited
0140-9174
DOI 10.1108/01409170810846858
The author thanks the personnel and officers of the Sandra Ann Morsilli Pacific-Basin Capital
Markets Research Center at the University of Rhode Island (PACAP) for supplying the data for
this study. The purpose of this organization is to promote both research and teaching about the
Pacific-Basin. All data are from the daily price file.
under the paradigm of the ‘‘random walk theory’’ of stock market prices. In this paper, Capital market
we study HKEx to focus on one of the most important and growing exchanges in the
Pacific-Basin.
efficiency
Capital market efficiency is an important research topic since Fama (1955, 1970)
explained these principles as a portion of the hypothesis involving capital market
efficiency. Following Fama’s work many capital markets researchers devoted
themselves to investigating the randomness of stock price movements. Their purpose
was to demonstrate the efficiency of capital markets. Later, other studies demonstrated
143
market inefficiencies by identifying systematic and permanent variations in stock
market returns. Some of these systematic variation or anomalies as they are referred to
be small firm effects, investment recommendations and extraordinary returns to time
and/or calendar effects.
Using variance-ratio statistical tests, Lo and MacKinley (1988) rejected the
hypothesis that prices follow random walks for daily and weekly returns. They found
no empirical evidence against the random walk hypothesis for monthly returns. They
determine, however, that portfolio returns of the New York stock exchange (NYSE) and
the American stock exchange securities exhibit significant first-order serial
correlations while security returns present negative first-order autocorrelation,
although statistically not significant. These results corroborate French and Roll (1986).
Lo and MacKinley (1990) studied this controversy to explain why the signs of the
autocorrelation coefficients for portfolio returns and stock returns differ. Stated
differently, they studied to determine the cause of one having a positive sign and the
other a negative sign. They concluded that the difference on sign of coefficients related
to whether one models a lead–lag relationship or one without lead–lag relationship.
The import of their result was to indicate that no matter how one accomplished the
modeling, a statistically significant result for the autocorrelation coefficient ensues.
Poterba and Summers (1988) found negative serial autocorrelation in monthly returns
for a NYSE value-weighted index during the period 1926-1985. Others including Lo
and MacKinley (1988) obtained different results for a different time period. Jarrett and
Kyper (2005a) found that many time series of closing prices of stocks in the United
States of America (USA) exhibited a unit root identified by the augmented Dickey–
Fuller (ADF) test. The ADF permits one to determine if knowledge of unit roots of lags
greater than a lag of one period helps to determine the statistical properties of time
series. These statistical properties help a forecaster to find the best and most simple
model for forecasting. Stated simply, the ADF indicates the appropriate number
autoregressive and/or moving-average terms that explain the variation in a time series
and enable one to model parsimoniously the financial time series under study. By so
doing, one can determine if a time series contains variation associated with the day of
the week. If so, time series properties are predictable and provide evidence that such
time series do not arise from efficient capital markets.
Calendar or time effects also contradict the weak form of the efficient market
hypothesis. The weak form refers to the notion that the market is efficient in past price
and volume information and we do not predict stock return and price movements’
accurately using historical information. This follows from many previous studies
including ones published before by the author and others (Rothlein and Jarrett, 2002;
Jarrett and Kyper, 2005a, b). If variation in financial time series of daily prices or
securities markets exist, market inefficiency is present and investors may earn
abnormal rates of return not in line with the degree of risk they undertook (Francis,
1993). The emerging literature in this area concerning studies of USA and United
MRN Kingdom (UK) securities include Balvers et al. (1990), Black and Fraser (1995), Breen
31,2 et al. (1990), Campbell (1987), Caporale and Gil-Alana (2002), Clare et al. (1994, 1995),
Fama and French (1989), Granger (1992) and Pesaran and Timmermann (1994, 1995,
2000). Bowerman and O’Connell (1993) can be consulted for additional details on
methodologies discussed in these studies.
The expansion of time series analysis as a discipline permits one to analyze stock
market prices in ways not previously explored. In particular, ‘‘what is the predictability
144 of the error term’’ and ‘‘is there predictability in daily stock market returns’’. Peculiar
problems arise when daily patterns are present in stock price data. We know that stock
prices possess patterns known as daily effects. Previous studies by Kato (1990a, b)
indicate very important aspects associated with variation of stock returns and closing
prices associated with the day of the week. These studies along with Ray et al. (1997),
and Moorkejee and Yu (1999) suggested that patterns exist in the time series of stock
exchanges in Japan, Shanghai and Shenzhen. These studies were unique in that they
investigated returns for individual firms and not for indexes of stock exchange
behavior. Other studies indicating the predictability of stock exchange behavior in Asia
include Kubota and Takahara (2003). They investigated whether the activity of
financial firms creates value and/or risk to the economy within the asset pricing
framework. They used stock return data from non-financial firms listed in the first
section of the Tokyo stock exchange. Their value-weighted index which was solely
composed of non-financial firms was augmented with the index of the firms from the
financial sector. In turn, they estimated the multivariate asset pricing model with these
two indices. We note that their procedure can simultaneously take into account the
cross-holding phenomena among Japanese firms, especially between the financial
sector and the non-financial sector. In conclusion, their financial sector model helps
explain the return and risk structure of Japanese firms during the so-called ‘‘double-
bubble’’ period indicating some predictability in closing prices of Japanese securities.
Last, Jarrett and Kyper (2006) studied the predictability of daily returns on more than
50 firms listed on exchanges in the USA and concluded that daily variation exists and
the time series contain predictable properties. Our methodology will follow from the
studies noted above.

Methodology and results

The predictive model for measuring the effects of changes in the day of the week on
closing prices of a security is:

Y ¼ bo þ b1 X1 þ b2 X2 þ b3 X3 þ b4 X4 þ b5 X5 þ "

where Y, daily return for the security; X2, dummy variable for Tuesday (one or zero
when not Tuesday); X3, dummy variable for Wednesday (one or zero when not
Wednesday); X4, dummy variable for Thursday (one or zero when not Thursday); X5,
dummy variable for Friday (one or zero when not Friday); ", error term with mean of
zero; and bo, intercept of model.
Note that we borrow from the methodology employed by Jarrett and Kyper (2006) in
their study of firms listed in United States stock exchanges. We collected data on 601
firms listed on the Hong Kong stock exchange in 2002. The data are for the fiscal years
2002 for Hong Kong. All data came from the daily stock price file, company file daily
exchange for Hong Kong. We selected this exchange because it is the third exchange in
the Pacific-Basin and the second largest set of files collected by the Sandra Ann
Morsilli Pacific-Basin Capital Markets Research Center at the University of Rhode Capital market
Island (PACAP). Files for China are not available at this time. Other Asian exchanges
are considerably smaller although Singapore can no longer be considered a small
efficiency
exchange. The Japanese exchange is currently under study but as yet, not completed.
The study period was the latest data available at the beginning of this study. Since
we had more than 300 days of closing data for each firm for each exchange, we
concluded that sufficient data were available for an extensive analysis. PACAP collects
the data from the stock exchanges themselves so their data are the same as if one were
145
to follow the end of day data for each trading day of the year for each exchange. The
methodology for reporting these data are thus the same as if the researchers collected
the data themselves on a day-to-day basis.

Results
Estimations for the ordinary least squares models for Hong Kong time series data sets
produced results noted in Table I for the response variable of closing daily prices. For
the Hong Kong data set the tests for significance of the dummy variable for day of the
week indicated some very important results. We rejected the null hypothesis that the
coefficient for the dummy variable for day of the week equaling zero since our results
produced t-statistics ranging from 2.24 to 3.45 with p-values ranging from 0.0248 to
0.0006. These results indicate that for the Hong Kong stock exchange that each day of
the week has a separate regression resulting in five parallel lines when plotted on a
time series graphs. This is the result that we were hoping would occur. The test for no
evidence for overall regression result produced an F-statistic of 3.63 and a p-value of
0.0058. This indicates that entire regression taken is useful for predictive and
explanatory purposes.
Plots of residuals (not shown here) did not produce evidence of a violation of the
usual assumptions concerning the error term (i.e. linearity, homoscedasticity and serial
correlation) of least square regression. Regression results are always subject to
limitations on the sample study period and the elements (firms) under study. However,
the compelling results indicate for the Hong Kong stock exchanges that there is a day

Source df Sum of squares Mean square F-stat P > Fa

Model 4 228,779,041 57,194,760 3.63 0.0058

Error 141,201 2.224363E12 15,753,164
Corrected total 141,205 2.224591E12
Parameter estimates
Variable df Parameter Standard t-stat Pr >|t|b
estimate error

Intercept 1
2,142.06097 24.30188
88.14 <0.0001

X2 1 75.25902 33.53432 2.24 0.0248
X3 1 116.90470 33.86295 3.45 0.0006
X4 1 103.47018 34.02725 3.04 0.0024 Table I.
X5 91.65600 33.69053 2.72 0.0065 Hong Kong stock
exchange data
Notes: aIndicates p-value; bData computed by SAS software. We modified the original SAS dependent variable:
appearance of the output to fit the purposes of this study and to make it more cosmetic closing price
MRN of the week effect on the closing prices of securities. We not further that the notion that
31,2 closing prices of securities for these firms in the Hong Kong markets follow random
walks is in doubt. We do not dispute that these markets do not function well, and that
competitive in which consistent abnormal profits based on public or historical
information are rare.

146 Conclusions
We document in this study that daily closing prices for a huge number of firms listed
on one of the largest Asian stock exchanges contain properties, which one can
measure, model and use for prediction. With enough time, patience and understanding
of the mathematics of the underlying processes that give rise to a time series,
forecasters can properly model these time series. The result would permit a forecaster
to conclude that the time series of closing prices are not random and do have daily
affects. Hence, in this study, we indicate substantially the existence of time series
components in closing prices of a randomly selected set of firms traded on the third
largest Asian stock exchange.
The results corroborate results of previous studies of international markets and
previous studies of markets in other nations where time series daily and monthly
components are present in closing prices and indexes of prices and returns of
securities. When these properties in closing prices exist, it is possible to forecast the
patterns, and thus investors can benefit from this information. Furthermore, the results
indicate that the weak form of the efficient markets hypothesis is in question when one
must make decisions concerned with investing in stock market securities. Daily
variation is neither random nor stochastic and it is possible to predict daily patterns
with some degree of accuracy.
We suggest, for purposes of prediction, that forecasters predict systematic time
series components of closing prices. In addition, one cannot understate the importance
of stock returns and portfolio risk. These factors coupled with recognition of
systematic time series components (daily variation in this study) in stock prices can
make one a better forecaster for prices of individual securities and contribute to the
literature on capital market efficiency. One last question concerns the out-of-sample
trading profit opportunities. Finding in-sample profit opportunities can be thought of
as a ‘‘data-mining’’ result, that is, if you fit many models a few will randomly have high
coefficients of determination and/or statistically significant model coefficients. We
suggest using parsimonious (least costly) models; the profitable opportunities should
be greater than transaction costs that may include bid-ask spreads and commissions. If
so, we can find profitable trading opportunities in rapidly growing markets in Asia.
When the opportunity arises to examine data for China and other emerging Asian
exchanges, we expect additional studies of those huge and growing markets. We are
only limited by our ability to collect sufficient and reliable data.

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About the author

Jeffrey E. Jarrett PhD is a former Chairperson of the Department of Management Science and
Professor of Management Science and Statistics at the University of Rhode Island. He holds
degrees from the University of Michigan and New York University where he studied with
W. Edwards Deming, among others. He has published extensively in international journals
including The Accounting Review, Decision Sciences, Management Science, Journal of Finance
and Journal of Business and Economic Statistics. Jeffrey E. Jerrett is the corresponding author
and can be contacted at: jejarrett@mail.uri.edu

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