Weak Form Efficiency of the Government Bond Market of Sri Lanka

8/11/2019 Weak Form Efficiency of the Government Bond Market of Sri Lanka

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WEAK-FORM EFFICIENCY OF THE GOVERNMENT BOND MARKET OF SRI LANKA

Background and the Research Problem

Emerging capital markets (including stocks, bonds and forex) seem to share common characteristics

such as rapid growth, transition, evolution and transformation into developed markets (Rockinger and

Urga 2000). Thus, lessons learnt in one market may be extended beyond its geographical limitations. Sri

Lanka Government securities Market, is an emerging one (as per Dow Jones index), that would provide

such a suitable territory to conduct studies, focusing at common salient features such as market

efficiency.

Absolute Public Debt as at end 2010, numbered at LKR 4,590.24 billion. Total debt as a percentage of

GDP was at 81.9% for the year 2010 with the total interest cost for the government for the same year

being LKR 352.6 billion. On average, weekly secondary market transactions amount to LKR 100 billion

(approximately). These numbers indicate how massive the trading volumes and the costs involved are,

making the Government securities market makes an important part of the countrys capital market.

The Central Bank of Sri Lanka, on behalf of the Government of Sri Lanka makes Initial Public Offerings

(Primary Issues) through primary auctions to the dedicated Primary Dealers that are entitled to make

bids at Primary Auctions and to make Secondary Sales of debt stocks to any other party in the secondary

market.

Severe competition to win at Primary Issues and to make higher margins at Secondary Sales implies high

information sensitivity that might lead to speculative trading. If the speculators could make arbitrage

profits, it is excess cost and a risk to the Government. Main Research Problem focused in this paper

is: Can the Primary Dealers make arbitrage or abnormal profits in this Market using historical data such

as past yield rates?

Justification

Governments aim is to borrow money at lowest possible cost at prudent degree of risk. However,

limited access to the funds in the market coupled with high borrowing pressure on the government and

also speculative trading has complicated the pricing mechanism and serious doubts arise whether the

fundamental/efficient price is arrived at. If not, it is market inefficiency and it leads to extra cost of

borrowing and high risk to the borrower, overstressing deficit financing and the market development.

For example, increase of 1 per cent in securities rates (on average) will increase the cost of borrowing

approximately by Rs. 5 billion. Absence of market efficiency in such a relatively young debt market could

seriously limit the Governments ability to raise funds at the lowest possible cost with prudent degree ofrisk. As Fama (January 1965); (May 1970) shows in Efficient Market Hypothesis (EMH), inefficiency

means investors earning abnormal returns that will become an abnormal cost to the government.

Therefore, debt managers and the regulator should know the efficiency (at least at its weak-form) of

their own securities market at least for two good reasons. First is to know whether the fundamental or

efficient prices are arrived at minimizing the cost of borrowing. Second reason is to assess the


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efficacy of implementation of fiscal, monitory and foreign exchange policies, on arriving at an efficient

market.

Objective and Hypothesis

Main Objective is to test the weak-form efficiency of the Government securities market of Sri Lanka. The

hypothesis is that the securities yield series do follow a random walk is tested in this paper in order to

assess the weak-form efficiency of the market.

Methodology

Weak-form efficiency is tested using the Random Walk Model (RWM). Securities price series are tested

for randomness properties using series of techniques. As per Famas definition (January 1965), the

central hypothesis behind tests of randomness is that the securities prices should show independent

identically distributed (iid) properties and the shape of distribution of price changes should confirm

Normal/Gaussian Distribution.

Data set consists of time series data for daily secondary market yield rates of Treasury securities and

Treasury bills for the period of 2007-2010. Sub-samples (series) are three-month Treasury bill, six-month

Treasury bill, two-year Treasury securities and three-year Treasury securities. Attention is paid to adjust

for missing data values by using log values of daily securities yields.

Those sub-samples are tested for their randomness properties using five econometrics techniques.

Robustness of the procedure is increased by employing both strong traditional tests and novel

techniques that have been used in both developed and emerging markets, as suggested by Mobarek,

Sabur Mollah et al (2008).

Five tests that have been employed are Unit Root test, Correlogram test, Histogram-normality test,Granger-causality test and Auto Regressive Conditional Heteroscadasticity (ARCH) test. All four sub-

samples are tested for Unit Root to ascertain randomness properties of the series by determining

whether the series are stationary or non-stationary. Non-stationary series confirms to a random

behavior of the financial time series. Autocorrelation between past yield rates and current yield rates is

determined by a Correlogram test. Low Q-statistics value would confirm that the series is non-

stationary. These two tests are employed to assess stationary of all four securities yield series. As per

Fama (January 1965), it is required for any random walk model to establish the shape of distribution of

the series. Histogram-normality test is employed in this paper to see how the series are distributed and

how do the mean and the median is spread within the series.

ARCH process is employed to model the volatility of error term which is an indicator of risk. ARCH

process shows the volatility of returns of a financial asset and establishes the possibility of estimating

future returns. It is well established in finance that the ability of estimating future returns is a key

determinant of its market price. If estimates with reasonable accuracy could be given for future returns

of an asset, it would imply forecastability of future prices with some degree of accuracy which in turn


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leads to market inefficiency. Granger Causality Test shows the relationship in-between the series. This

test helps to identify whether there is any causality in deciding yield of one series on another.

Outcomes

Descriptive statistics mean, median standard deviation, skewness and kurtosis shows that all four series

postulate mean-reversion with stable mean but volatility is time-varying. As per the RWM, all four series

confirm stationary time-series. Correlogram tests shows the result of that all four series have high Q-

statistics value implying long-term correlation in-between yields of the series. This again confirms

stationary time series for all sub-samples. ARCH process to test the volatility of error term indicates that

is autoregression and correlation in between observations in all four series. Unit Root test also shows

that for all four series, ADF Value is much greater than the critical value at 1% level. These results

confirm that the series are stationary with stable mean and changing volatility. Distribution of price

changes show that the median and standard deviation tend to vary around the mean, implying a

stationary time series.

Granger Causality test on term structure gives the outcome that Treasury bill rates are correlated with

each other and Treasury securities rats are correlated with each other but there is no evidence as per

existence of relationship between Treasury bill and Treasury securities rates.

Conclusion and Recommendations

The conclusion based on overall results of all the five tests is that all securities yield series show some

stationary properties denying adherence to RWM. Therefore, it is not possible to conclude that the Sri

Lanka Government securities market is weak-form efficient. This implies that there may be possibility to

beat the market through trading strategies based on historical data (including macroeconomic variables

as per Famas new definition (December 1991)).

However, since this market possess characteristics of an emerging one, it would be interesting to

explore further, how the efficiency had changed overtime in response to environmental (regulatory)

changes. This is recommended because there is responsibility of any government to make proper policy

and regulatory changes to the Government securities market so that the market undergoes correct

evolutionary path towards market efficiency.

List of References

Fama, E. F. (December 1991). Efficient Capital Markets II.The Journal of Finance XLVI(5): 1575-1617.

Fama, E. F. (January 1965). The Behavior of Stock Market Prices.The Journal of Business 38(1): 34-105.

Fama, E. F. (May 1970). Efficient Capital Markets: A review of Theory & Empirical Work.The Journal of

Finance 25(2): 383-417.

Mobarek, A., A. Sabur Mollah, et al. (2008). Market Efficiency in Emerging Stock Market: Evidence from

Bangladesh.Journal of Emerging Market Finance 7: 17.


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Rockinger, M. and G. Urga (2000). The Evolution of Stock Markets in Transition Economies.Journal of

Comparative Economics 28: 456-472.

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Weak Form Efficiency of the Government Bond Market of Sri Lanka