Understanding the Behavior of Stock Returns and Stock Prices

Understanding the Behavior of Stock Returns and Stock Prices

Introduction

For the past three decades, investors have been interested in the behavior of the stock prices. Over the period of time, the stock market observers made attempts in order to discover whether the movements in the stock prices have followed a pattern that is discernible in nature.

This report is aimed at understanding the concept of efficient market hypothesis, and to further elaborate this concept we are using data of historical returns. In addition, statistical modeling is also incorporated to further clear the concept of EMH.

Discussion

Section A

Overview of Selected Stock Market

Stock Market that we are selecting for our analysis is Standards and Poor's 500 index, it is an American financial service company. It was established in 1860 and is a separate division of McGraw Hill Financial. Around 10,000 employees are working under the shelter of S & P whereas its reported sales for year 2012 are 10.41 trillion dollars. S & P is considered as one of the most growing and prominent stock index of America. It is headquartered in Manhattan, New York City.

Explanation on Monthly Returns Effect

Monthly return effect can be defined as a brief rise in the prices or returns of stocks during some of the few days of month in the beginning and at the end or more specifically increase the price of share at the last trading day of the month and initial three trading days of the next month. The pattern of turn of the month effect can be understood from the chart below, which shows the black line as the return on stock in the remaining days of the month, blue line represents the return on stock during all seven days of the week and red line represents the turn of the month effect of return on S&P 500 stocks as explained above in the historical documentation of TOM.

Explanation on Efficient Market Hypothesis and its Three Forms

It is an investment theory that says that it is not achievable to thrash the market as the efficiency of the stock market causes the current prices of the shares to always include and provide a reflection of all the information that is relevant. According to the Efficient Market Hypothesis, stocks are generally traded on their fair value on their stock exchanges, and it makes it impracticable for the financiers to buy the stocks that underestimate or sell the stocks that have inflated prices. In financial literature following forms of EMH are discussed

Weak Form Test

In weak form test, one cannot predict future prices on the basis of past prices of shares. Gain on average return in excess amount cannot be earned for long term by analyzing past prices or information using investment strategies. Share prices have no pattern and show signs of no serial dependency. It means future prices are not on price series, but entirely determine by ...