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This research looked at the concept of market efficiency in the weak-form and tested these in a sample of African stock
markets- the Johannesburg Securities Exchange (JSE), the Egyptian Stock Exchange (EGX), the Kenya Nairobi Stock
Exchange (Kenya NSE) and the Nigeria Stock Exchange (NSE) - selected as representative of the continent’s stock
markets. The FTSE/JSE Africa All-share index, the Hermes Financial index (HFI), the Kenya NSE-20 index and the
Nigeria All-share index respectively were used as proxies for these markets.

In the study non-linear modelling (runs test and the Wilcoxon Signed Rank test) was used so as to avoid deriving
erroneous results due to the assumptions on linearity made under linear modelling. In addition in order to capture the
real return generating process in these markets weekly returns were collected in an international currency- the US

The aim of the study was to present the international investor with practical and relevant evidence on the efficiency
levels of African stock markets, an area that has become of keen interest to the international investor seeking to
diversify his portfolio and earn higher returns. To venture into these markets the investor needs the assurance that
stocks are correctly priced to facilitate maximum return on the allocation of resources. Any predictability and
autocorrelation in return series would compromise such efficiency in pricing and it was the intention of this study to
test these efficiency levels in the weak-form.

On the basis of this research all four markets were found to be weak-form inefficient in particular due to liquidity
issues that contributed considerably to detected autocorrelations. These results were further confirmed by semi-strong
form efficiency tests on stocks randomly selected from the relevant indices.

By adopting a triangulation approach in arriving at the study results the robustness of these results was confirmed.

-1- © 2009 PK Mwangi Global Consulting

1: Introduction
1.1: Research Rationale:
In light of the recent turmoil in the world financial markets, investment portfolio diversification across region and asset
class has become all the more critical to the success of the international investor. More and more international investors
are looking to emerging markets to diversify their risk and earn higher than average returns. In particular, previous
research (Ayadi et al., 1998 p.24) has shown that African stock markets are decoupled from other major stock markets
thereby creating the potential to earn positive returns since correlation is a factor in determining the cost of capital.
Lower correlation validates a lower discounting of future expected returns from a particular investment opportunity
thereby encouraging the allocation of resources in that direction. (Christofi and Pericli, 1999 p.79)

Not only emerging stock markets in Asia, the Middle East and Latin America, but also emerging African stock markets
have seen tremendous growth in the last decade and an increasing focus by international investors. According to
Standard and Poor’s(2008a), a leading publisher of financial research and analysis literature, international gross
portfolio inflows into Africa, excluding South Africa, increased from almost nil to $23 billion between 2001 and 2006
while gross foreign direct investment increased from $15 billion in 2001 to over $20 billion by 2006. In addition total
market capitalisation on the continent quadrupled between 2002 and 2007 from US$ 250billion to almost US$1.2
trillion (see Appendix IV) while between 1997 and 2004 five key African stock indices grew by in excess of 100 %.1

This is a clear indication, not only of the recognition of opportunity in emerging Africa by international portfolio
investors, but also the increased economic activity that will be spurred by the massive FDI inflows which should
further spur stock market development in these economies and boost the international investor’s confidence. The latter
may be wary of the risks involved in venturing into underdeveloped and inefficient markets. The figures also give a
clear indication of the return generating potential these markets hold for the international investor. However, the key
question is whether these markets are efficient enough to allow the international investor to exploit this potential.
In early 2008 Standard and Poor’s launched three new benchmark indices – the S&P Africa 40
index, the S&P Africa Frontier index and the S&P Pan Africa index to track the performances of
leading companies and equity markets on the African continent. The indices are meant to provide the international
investor with tangible evidence of areas into which to diversify his portfolio and are a clear indication of the growing
importance of the continent to investors seeking an alternative or expanded horizon for their investments. (Reuters,

In accessing the return potential of these markets and their ability to allow a diversification of the international
investor’s portfolio a valid indication of their real return generating process is critical. Most previous research on

Between 1997 and 2004 the Botswana Domestic Composite Index grew by 298%, the Egyptian CCSI by 239%, the Ghana GSE All share index by 198%, the
Nigeria LSE All share index by 264% and the South Africa JSE All share index by 114% (Yartey and Adjasi, 2007 p.6; Chukwuogor, 2008 p.375)

-2- © 2009 PK Mwangi Global Consulting

market efficiency on African stock markets has measured returns in domestic currency2 ignoring the implications of
their usually high inflationary environments (see Appendix III) and weak exchange-rate regimes. Exchange rates of
African currencies against major international currencies like the US dollar, Euro or British pound are particularly
volatile and even where returns (measured in local currency) are high, the benefit may not be apparent when the returns
are measured in an international currency like the US dollar. Thus this study attempted to fill this gap in the literature
by using an international currency in testing the efficiency in these markets and hence deriving a more accurate
assessment of the return generating process.

Without going into the complexities involving the exchange rate movements in the individual currencies of the
countries involved, this research approached the issue of real returns by measuring them in US dollars as a proxy for
the international currency. The obvious advantage here was that the use of an international currency in tests of
efficiency would dampen any bias towards autocorrelation where local currencies were used as evidenced in Karemera
et al. (1999 p.183)3. It is this real return generating process and the identification of efficiency using such returns that is
critical to the international investor in assessing whether the African stock markets represent a worthwhile window of
investment opportunity.

As widely documented in the literature ((Fama, 1981 p.545; Kaul, 1987 p.255) inflation and real return are negatively
correlated. Rising inflation in most African economies reduces the return based on local currencies i.e. as a result of
inflation a higher expected return is needed to yield a similar return to that before the incidence of inflation. To the
international investor, inflation in these African markets means a depreciation of their local currencies.

Measuring returns in the local currency will therefore give an inaccurate assessment of real return where these are not
adjusted for inflation. By measuring returns in the international currency, the international investor is able to capture
the true nature of the return generating process, as the inflationary component is eliminated through the exchange rate
mechanism. This is illustrated in Table I below. Thus the international investor is able to reach a better informed
decision about his investment plans…

This includes the works of Magnusson and Wydick (2002), Appiah-Kusi and Menyah (2003), Jefferis and Smith (2004, 2005) and
Billmeier and Massa (2008) among others.
Returns from selected emerging markets measured in international currency are more consistent with RWH. When the same results are
measured in local currencies for the same markets there is a higher rejection of RWH.
-3- © 2009 PK Mwangi Global Consulting