Lecture 7: Runs Test

Methodology
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Runs Tests

• Today we are looking at the application of The Runs Test methodology.

• There is an example paper using Runs Tests on Moodle and also an Excel
programme to undertake runs tests and serial correlation tests. You are
welcome to use this programme for your dissertations.

• Runs tests are used to test weak-form market efficiency by testing is the
market is following a random walk.

• We will go through an example that measures efficiency of the Amman

Securities Exchange in Jordan from 1992 to 2007.
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Runs Test: methodology for a proposal

• The methodology is the key part of your proposal. You therefore need to
outline on how you will use this model in your research.

• Theoretical Background: Efficient Markets Hypothesis.

• Weak form efficiency was defined by Fama in terms of the current share price
reflecting all publically held information.
Efficient capital markets: a review of theory and empirical work. The Journal of Finance. 25: 383–417.

• If markets are weak-form efficient prices will only change in response to new
and unforeseeable information. Each new piece of information will move the
share price – some will move it up, some down and some sideways. The
direction will however be random.

• This is the random walk.

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Runs Test: methodology for a proposal

• If however the direction of the share price is not random then we cannot
argue that the market is weak form efficient.

• If the market shows a large number of ‘runs’ of price in the same direction
then we reject the hypothesis that it follows a random walk.

A run is where the price goes in the same direction (up or down) over a number
of consecutive periods. We will do the ‘number-of-runs’ test. There is also a
‘length of runs’ test.
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Runs Test: methodology for a proposal

• We set up the hypothesis to be tested:

Ho : the market follows a random walk (observed runs = expected runs )

H1: the market does not follow a random walk (observed runs ≠ expected runs )

• The null, of markets being efficient, is only rejected if there is less than 5%
chance of it being true.

• The test undertaken uses the Z or normal distribution.

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Runs Test: methodology for a proposal

• We compare the actual number of runs [R] in the series ( positive and
negative) against the ‘expected’ number of runs [ E(R)] where expected is the
number we would observe if the series followed a random walk. The formula
is as follows (N = total number of changes):
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Runs Test: writing the methodology for a proposal

• We will now have a look at the Excel file and how we undertake the event
study.

• The only data that we need is the daily ASE closing index value.

• The programme will work out everything else for us.

• Note the programme also does serial correlation and length-of-runs tests. We
like to do multiple tests for robustness checking.
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Runs Test: writing the methodology for a proposal

• Programme output

Put data in here

The Z-test calculated

value and the test
statistic critical value

The observed runs

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Runs Test: writing the methodology for a proposal

• The results of the number-of-runs test show that calculated z-statistic (13.94)
and well above the critical value (2.575).

• therefore we reject the null and conclude that the ASE does not follow a
random walk and is not weak form efficient.
Total runs 2394
n1 (+ve returns) 1961
n2 (-ve returns) 1953
N (total returns) 3914
E (R ) 1957.99182
St Dev 31.2768566
Note these tests do not account for drift in the series i.e. they assume stationarity.
Number-of-runs-test
Z= 13.9402812

2-tail at 1% 2.575
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Runs Test: Exercise

• The file on moodle Lecture 7 SSE Runs Test produces a runs test on the share
price of the UK utility company SSE using daily share price data over the
period 24/01/2000 – 13/05/2015.

• You are required to test whether or not the market for SSE shares is weak
form efficient.

• 1. set up you hypothesis to test

• 2. can you reject the null hypothesis?
• 3. What do your results tell you about whether SSE follows a random walk?
• 4. Are the results as you might expect for a large FTSE100 company?