A procedure for testing the hypothesis of weak efficiency in financial markets: a Monte Carlo simulation

Abstract

The weak form of the efficient market hypothesis is identified with the conditions established by different types of random walks (1–3) on the returns associated with the prices of a financial asset. The methods traditionally applied for testing weak efficiency in a financial market as stated by the random walk model test only some necessary, but not sufficient, condition of this model. Thus, a procedure is proposed to detect if a return series associated with a given price index follows a random walk and, if so, what type it is. The procedure combines methods that test only a necessary, but not sufficient, condition for the fulfilment of the random walk hypothesis and methods that directly test a particular type of random walk. The proposed procedure is evaluated by means of a Monte Carlo experiment, and the results show that this procedure performs better (more powerful) against linear correlation-only alternatives when starting from the Ljung–Box test. On the other hand, against the random walk type 3 alternative, the procedure is more powerful when it is initiated from the BDS test.