Market Efficiency, Thin Trading and Non-Linear Behavior: Emerging Market Evidence from Sri Lanka

This paper investigates the efficiency of Colombo Stock Exchange (CSE) taking into account the possibility of non-linearities in the price time series, and thin trading characteristics of the Sri Lankan stock market. We use the data on the All Share Price Index (ASPI) for the period from January 1990 to December 2009. We use an AR(1) model to estimate the residuals of the AR(1) equation, and then adjust the returns for thin trading. In addition to that an augmented logistic equation model is used as a basis for investigation to take into account the nonlinearity in the data. The study finds significant autocorrelations in the unadjusted daily market returns for thin trading for the period of 1990 to 2009. However, the above predictability is removed when we use thin trading adjusted returns to the model. After incorporating non- linear components into the model, we find that statistically significant non linearity in the CSE after and before adjusting returns for thin trading. Therefore, we can conclude that the inefficiency observed at CSE during the sample period is manifested through non-linear behaviour of stock returns. We further examine the models on annual sub-sets of the index data in order to investigate the effectiveness of market regulatory changes on market efficiency at CSE. Unlike the other emerging markets we do not see that regulatory changes have significantly encouraged investor participation, improved information quality and reflected new information more rapidly in share prices. Therefore, further measures are necessary to improve the informational efficiency of the CSE. In this regards allowing short sales and introducing risk hedging derivative securities to the market would be effective.