DEPARTMENT OF MATHEMATICAL SCIENCES

UNIVERSITY OF ESSEX

MA 902

RANDOM WALK IN FINANCIAL MARKETS

BY

OCHUBA BENEDICTS CHIDIEBERE

1. Random walk hypothesis

There is an on-going debate on the accuracy of the use of random

walk hypothesis in describing the reality of stock price behaviour

(Cootner, 1962; Fama, 1995; Conrad, 2000; Chaudhuri and Wu;

2003; and Dupernex, 2007). The crux of the matter is that if random

walk theory provides an accurate description, then the many

technical or chartist procedures suggested for predicting the

behaviour of stock prices are completely invalid. Malkiel (2011: p.

26) sees a random walk as one in which future steps or directions

cannot be predicted on the basis of past histories, and considers

investment advisory services, earning forecasts, and complicated

chart patterns for studying stock price behaviour as useless entities

when stock price behaviour is considered. In application to stock

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market dynamics, a random walk process is that unpredictable

short-run changes in stock prices.

Essentially, the chartists or technical theorists assume that history

tends to repeat itself, which means that past patterns in stock price

behaviour of individual stocks would be expected to recur in future

period; this motivates the proponents

1
of chartist theory to predict future prices by developing a familiarity

with past pattern in the price behaviour of the individual stocks with

the aim of recognizing situations of likely recurrence. Hence, their

views of the behaviour of stock prices are believed to be

encompassed with some level of mysticism (Fama, 1995). In

technical terms chartist approach to stock price prediction using the

knowledge of past behaviour is characterized by the assumption

that successive price changes in individual stock prices are

dependent; hence, using the chartist theories, it is assumed that

the sequence of price changes prior to any given day is important

in predicting the price change for that day (cf: Fama, 1995; p. 75).

It is claimed that financial time series are often well approximated

by total random walk. If y(t) represents the financial time series in

question, a random walk process will normally take the following

general form:

(1.1) y(t) = y(t 1) + u(t),

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where u(t) represents an error term with zero mean, and whose

values are independent of each other. In essence, from the

expression in (??), one can write u(t) as the change of y(t) with

respect to t; in other words, u(t) is the change in y(t) denoted by

y(t), which is defined as y(t) = y(t)y(t1). The change y(t) is

independent of previous changes, i.e., y(t1),y(t2),.

Furthermore, from the work of Mills (1993), one can show that,

following the representation in (??), higher conditional moments of

y(t) (for instance, the variance of y(t)) are also independent of

the moments of previous changes in y(t). Consequently, this

particular observation has raised questions regarding the validity of

the random-walk hypothesis as a reliable theoretical model that

provide vivid explanation of the financial markets dynamics;

nevertheless, alternative formulations superior to other possible

approaches to the study of stock price dynamics have been

suggested.

One of such alternative formulation is realized in the form of a

martingale. This is given by the following expression:

(1.2) ,

where D(t) denotes the dividend paid out during period t. A

martingale is a stochastic (random) variable that has the property

that for any given information set, every investor is bound within
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the available information set, and can only make profits, which are

consistent with the risk inherent in the security (Dupernex,

2007). This formulation comes as an improvement to the random

walk model of (??), as it can be generated within a reasonably large

class of optimising models (cf: LeRoy, 1989; p. 1588).

As shown in Mills (1993), unlike the expression in (??), any

stochastic (or random) process whose path is described by the

expression in (??) does not support the conditional dependence of

y, but not with the case for any higher moments of y (LeRoy,

1989). This formulation supports the claim that one can observe

that financial time series often go through quiet as well as turbulent

periods.

This has led Mills to believe that using the martingale approach, the

quiet and turbulence periods can be modelled by a process in which

successive conditional variances (but not their successive levels)

are positively autocorrelated. However, this is not achieved with a

more restricted random walk process.

Another notable alternative formulation of the random walk

hypothesis for stock and/or asset price predictions is achieved by

the use of continuous appromixation of the random walk process

(Komlos, et al, 1975; Spitzer, 1976; Karatzas and Shreve, 1991;

Shreve, 2004; and Lawler and Limic, 2012). In particular, a Levy

process (Brownian motion, especially) has been found as a good

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continuous approximation to the random walk process. This

approximation, which is achieved through the (local) central limit

theorem (lCLT), allows easy development of the theory of stock

and/or asset price prediction. For instance, the independence of the

changes in current stock prices on past price behaviours is well

formulated.

Let us write yt y(t). Suppose we consider a one-dimensional

simple random walk represented by the following partial sum:

(1.3) Sn = y1 + y2 + + ynfor each n Z,

where Z denotes the set of integers. With the help of the (local)

central limit theorem (lCLT) (Lawler and Limic, 2012; Chapter 2), the

distribution of Sn, for fixed n Z, is fully described. In particular, a

corollary to the lCLT states that

the distribution of n1/2Sn converges to the distribution of a standard

normal random variable. This corollary is the usual central limit

theorem (CLT). Let

0 < t1 < t2 < < tk = 1, then by a simple extension, we have that

the distribution of the sequence:

n1/2 (St1n,St2n, ,Stkn)

converges to the distribution of the sequence:

(X1,X1 + X2, ,X1 + X2 + + Xk)

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as n ; where X1,X2, ,Xk are independent random variables each

with mean zero and variances t1,t2 t1,, and tk tk1, respectively.

Using the following linear interpolation:

St = Sn + (t n)[Sn+1 Sn], n 6 t 6 n + 1,

we can transform (??) into a (random) continuous function. In

particular, further extension using the Donskers theorem (or the so-

called invariance principle) for a random walk process yields the

following random function:

(1.4) .

Subsequently, a rough approximation, which follows from the

functional limit theorem (Karatzas and Shreve, 1991; Sato, 1999;

and Lawler and Limic, 2012), shows that as n , the distribution

of the random function defined in (??) converges to the distribution

of a random function given by t 7 Bt. From our understanding of

the stationary and independent increments of the simple random

walk process (refer to the discussions immediately following the

expression in (??)), a number of properties can be deduced and/or

proven for Bt. We summarise some of these properties as follows

(Spitzer, 1976; and Sato, 1999):

(1) Homogeneous or stationary increments property: If t > s, then the

distribution of Bt Bs is normally distributed with mean of 0 and

variance of t s; in notation form, we have that

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Bt Bs N(0,t s).

(2) Independent increments property: If 0 6 t0 < t1 < t2 < < tk for any

choice of k > 1, then Bt1 Bt0,Bt2 Bt1, ,Btk Btk1 are independent

random variables; in notation form, we can write

Bt1 Bt0 =d Bt2 Bt1 =d =d Btk Btk1

d where = denotes equality

in distribution.

(3) The random function: t 7 Bt is stochastically continuous (or

continuous in probability), and for every t > 0, and > 0, we

have

(1.5) lim

Further assumption that B0 = 0 a.s. (almost surely) reduces (??) to

0 as t 0.

The combination of properties (1) and (2) is named the stationary

independent increments property. Property (3) can heuristically be

deduced from the fact that

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which gives an indication that |Bt+t Bt| should be of order t. A

process satisfying these assumptions is usually called the Brownian

motion (named after the English Botanist, Richard Brown).

Detailed description and rigorous analysis of the properties of Bt

can be found in many standard materials on Brownian motion; some

relevant resources in this regard include the ingenious works by

Karatzas and Shreve (1991), Sato (1999), and Shreve (2004). There

is a number of ways of showing the convergence of

, as defined in (??), to the Brownian motion Bt in the limit as n

with much rigour. One of such ways is by first restricting and

Bt to the interval

0 6 t 6 1, which assumes that both and Bt take values in the

metric space C[0,1] with supremum norm. Then, one can compute

some estimates to show that there exist positive numbers c and a

such that for all r 6 n1/4,

where k k denotes the supremum norm on C[0,1].

Using Brownian motion to model stock and/or asset prices, Fisher

Black and Merton Scholes, in their seminal paper of 1973,

formulated a well-known means of computing asset prices under

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some suitable market conditions (Black and Scholes, 1973), which is

popularly referred to as the option pricing model. This formulation

has also been extended to other cases involving general Levy

processes that is, instead of the usual Brownian motion, a more

general Levy or Levytype process is used. This extension enables

one to capture jumps in stock/asset prices, which may also be

related to the quiet vis-a`-vis turbulent periods, as earlier

mentioned. Nevertheless, research in this area is still on-going.

Whichever way it is viewed, there is a general consensus that the

prediction of stock prices is a very difficult task. Moreover, the stock

prices do very much behave like a random walk process, at least in

the less restrictive sense, and particularly when the hit rates

generated by most prediction methods in use are considered. As a

matter of fact, this sort of consideration has a direct impact or

implications on the predictions, evaluations, and application tasks.

If the time series to be predicted is an absolute random walk

process, then the prediction task is impossible. Whenever this is the

case, algorithms for predictions of the sign of y(t) is only mildly

accurate producing only a 50% hit rate in the long run.

Consequently, as the best result possible, one can only expect a

near to random walk behaviour for the time series for which

prediction is attempted, but with limited predictability. Moreover, for

the predictions of stock prices, predictions with degrees of accuracy

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of 54% hit rate are often regarded as satisfying results (Taken,

1981).

We conclude by reviewing the work of some proponents who do

not believe that the random walk hypothesis is sufficient enough in

predicting financial market assets prices. It was suggested that

stock prices of the short-run serial correlations are not zero and that

short-run stock prices can gain momentum due to investors

responses to several consecutive periods of consistent price

movement of a particular stock (Lo and Mackinley, 1999) this is

typically referred to as the bandwagon effect. It was further argued

in Shiller (2000) that the effect of momentous gain in short-run

prices is most likely the cause of irrational exurberance that

characterised the so-called dot-com boom. On the contrary, the

long-run stock prices gave an evidence of negative autocorrelation

(Fama and French, 1988), a situation that has now been known as

mean-reversion. Nevertheless, its existence is not largely

supported by the works of many researchers. In Fama (1998), it was

argued that investors would initially over- or under-react to new

market information, and the serial correlation detailed above

explains the investors reaction to the information over time, which

has also been attributed to the bandwagon

effect.
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There is also a belief that relates the random walk hypothesis with

the efficient market-model hypothesis (EMH) (Fama and French,

1988; Fama, 1998; and Dupernex, 2007). However, it should be

noted that both random walks hypothesis and the EMH do not mean

the same thing; in other words, a random walk of stock prices does

not imply efficiency of the stock market with rational investors.

However, EHM is believed to be the basis underpinning the theory

that share prices could follow a random walk (cf: Dupernex, 2007;

p. 7). Since investors reaction to any informational advantages they

have is instantaneous, there are tendencies that profit oppotunities

can be eliminated; therefore, stock prices are believed to follow a

random walk, which is in connection with the EMH. In its earlier

stage, there were strong theoretical and empirical evidence

supporting the EMH that it was highly accepted. However, recent

research has seen an emergence of arguments contradicting its

validity. The implication of this development is the loss of faith in

the random walk hypothesis as a suitable theoretical settings for

predicting stock prices.

In conclusion, despite the many counter and/or contradictory

evidence for and/or against the random walk hypothesis, it is very

difficult to draw a conclusion on the validity or otherwise of the

random walk hypothesis. It is a general belief that data mining is a

major problem on its part, and the manipulation of the dataset in

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support of ones findings is not completely ruled out. Moreover,

most of the results could be due to some level of probability.

Concerns have also been raised that the incidence of missing out of

important risk factors during analysis is inevitable. Nonetheless, one

can accept the fact that stocks do approximately follow a random

walk, but there are other factors that appear to affect stock prices

as well; these factors have been listed in the work by Fama and

French (1995).

2. References

[1] Black, F. and Scholes, M. (1973): The pricing of options and corporate
liabilities. J. Polit. Econ., 81: 637-659.
[2] Brealey, R. A., Myers, S. C., and Allen, F. (2005): Corporate finance, 8th
Edition. New York: McGraw-Hill Irwin.
[3] Chaudhuri, K. and Wu, Y. (2003): Random walk versus breaking trend in stock
prices: Evidence from emerging markets. J. Banking & Fin., 27(4): 575-592.
[4] Conrad, J. (2000): A non-random walk down wall street: Book Review. J. Fin.
55(1):
515-518.
[5] Cootner, P. H. (1962): Stock prices: random vs systematic changes. Indus.
Mgt. Rev., 3: 24-45.
[6] Dupernex, S. (2007): Why might share prices follow a random walk? Stud.
Econ. Rev., 21: 167-179.
[7] Fama, E. F. (1998): Market efficiency, long-term returns, and behavioural
finance. Journal of Financial Economics, 49 (3):283-306.
[8] Fama, E. F. (1995): Random walks in stock market prices. Financial Anal. J.,
JanuaryFebruary, 75-80.
[9] Fama, E. F. and French, K. R. (1988): Permanent and temporary components
of stock prices. Journal of Political Economy, 96: 246-273.
[10] Fama, E. F. and French, K. R. (1995): Size and book-to-market factors
in earnings and returns. Journal of Finance. 50:131-155.
[11] Lawler, G. F. and Limic, V. (2012): Random walk: A modern
introduction. Preprint.
[12] LeRoy, S. F. (1989): Efficient capital markets and martingales. J. Econ
Lit. 27: 1583-1621. [13] Lo, A. W. and MacKinley. A. C. (1999): A non-random
walk down wall street. Princeton: Princeton University Press.
[14] Karatzas, I. and Shreve, S. E. (1991): Brownian motion and stochastic
calculus. New York: Springer-Verlag.
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[15] Komlos, J., Major, P., and Tusnady, G. (1975): An approximation of partial
sums of independent random variables and the sample df I & II, Z. Warsch. verw.
Geb. 32: 111131, & 34: 33-58.
[16] Malkiel, B. G. (2011): A random walk down wall street: The time-tested
strategy for successful investing, 10th edition. New York: W. W. Norton & Co., Inc.
[17] Mills, T. C. (1993): The econometric modelling of financial time series.
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[18] Sato, K-I. (1999): Levy processes and infinitely divisible distributions.
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[22] Takens, F. (1981): Detecting strange attractors in fluid turbulence. In Rand,
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