• Investment World
• eWorld
• Catalyst
• Mentor
• Life
• Canvas
• Praxis
• Urban Pulse
• Brand Quest

B. Venkatesh

A STUDENT of finance posed this question: Do stock prices in an efficient market follow a random walk? We can answer the question by looking at the meaning of efficient market and random walk.

Take Company X. If there is good information flow in the market, its stock price will reflect all information that is publicly available. If the company, for instance, has bagged a contract from a major client, the current price of the stock will reflect that information. We can then say that the investors have "efficiently" priced the stock.

Now extend this concept to the entire market. If prices in the stock market reflect all available information on each company, we can say that the market is "efficient". When the stock price reflects all public and private information, we say that the market is strong form efficient. If the stock price reflects only public information, we say that the market is either weak form or semi-strong form efficient.

So, how does efficient market help us in understanding stock price movements? We know that information drives stock prices. It follows logically that the change in stock price will be driven by the arrival of new information.

But we do not know when a new of set of information will arrive in the market. To use a financial parlance, we can say that information arrival is a random process. If the arrival of new information itself is a random process, the change in stock price should also follow a random process. So, we say that stock price follows a random process or a random walk. Of course, the assumption is that investors do not have access to inside information on the company. For investors who do, the market may not be "efficient", and may not, hence, follow a random walk.

Article E-Mail :: Comment :: Syndication

Stories in this Section
What record FII flows mean for equities

Copyright © 2003, The Hindu Business Line. Republication or redissemination of the contents of this screen are expressly prohibited without the written consent of The Hindu Business Line