An Empirical Test of German Stock Market Efficiency

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An Empirical Test of German Stock Market Efficiency
A Master Thesis submitted by Lindsay Gillette (188816) to Prof. Dr. Wolfgang Härdle in partial fulfillment of the requirements for the degree of Master of Science

C.A.S.E. – Center for Applied Statistics and Economics Institute for Statistics and Econometrics Humboldt-Universität zu Berlin

Berlin, Germany September 13, 2005

II

Declaration of Authorship
I hereby confirm that I have authored this master thesis independently and without use of other than the indicated resources. All passages, which are literally or in general matter taken out of publications or other resources, are marked as such.

Lindsay Gillette September 13, 2005

III

Acknowledgement
I would first like to thank Prof. Dr. Wolfgang Härdle for giving me the opportunity to write this thesis as well as for his stimulating Statistics of Financial Markets course. I would also like to express my appreciation to the Quantitative Research Group of Bankgesellschaft Berlin for allowing me to perform the entirety of the research and writing required for this thesis in their office. Particularly, I would like to extend my sincerest gratitude to Peter Schmidt who offered his expertise and guidance on a daily basis. Furthermore, I would like to thank Dietmar Hillebrand for his feedback and insightful suggestions. Last but not least, I am extremely thankful to have such a wonderful family, thoughtful friends and a loving mother who have provided me with warm support and who have been nothing but encouraging and understanding throughout this experience.

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Table of Contents
List of Figures........................................................................................................... V List of Tables ........................................................................................................... VI Notation ................................................................................................................. VII Chapter I Introduction ...............................................................................................1 Chapter II Theoretical Foundations .........................................................................3 1 Market Efficiency ...................................................................................................3 1.1 Random Walk Model.....................................................................................3 1.2 Efficient Market Hypothesis ..........................................................................4 1.3 Testing Market Efficiency..............................................................................5 1.3.1 Tests of Return Predictability .............................................................6 1.3.1.1 Time Patterns ........................................................................6 1.3.1.2 Predicting Returns From Past Returns ..................................7 1.3.1.3 Anomalies ..............................................................................7 1.3.1.4 Predicting Long-term Returns from Firm and Market Characteristics.......................................................................8 1.3.2 Event Studies .....................................................................................9 1.3.3 Testing for Strong Form Efficiency ...................................................10 1.4 Problems in Testing Market Efficiency ........................................................11 1.5 Models to Measure Expected Return..........................................................12 1.5.1 Market Model ...................................................................................12 1.5.2 The Capital Asset Pricing Model (CAPM).........................................14 1.5.3 Multifactor Models ............................................................................20

Chapter III Empirical Analysis...
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