Random Walk Theory And Behavioral Finance Theory

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CHAPTER TWO: LITERATURE REVIEW
2.1 Introduction This chapter will address theories relevant to the behavior of financial markets and specifically stock prices movement on release of new information into the market, followed by the determinants of stock price, international and local empirical evidence and finally a summary of the chapter.
2.2 Theoretical Review
This section will review the theories that will guide the study and their relevance to the study. The theories to be reviewed include; Efficient Market Hypothesis (EMH), Random Walk Theory and Behavioral Finance Theory.
2.2.1 Efficient Market Hypothesis (EMH)
The EMH is a popular investment theory in Finance developed by Fama (1965). According to the EMH, an efficient capital market
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2.2.2 Random Walk Theory
The Random Walk Theory is an important model used in economics and finance in testing stock price behavior (Fama, 1965). A random walk simply means that successive stock price changes are independent of each other, that is, the future price of stocks is completely independent of past trends (Mbat, 2001).
Kendall (1950) initially put forward empirical support for the view that stock prices do not behave in a systematic manner but are more akin to a random walk. Foley (1991) supported Kendall’s argument. According to Lo and McKinley (1999), stock prices always fully reflect all the available information and no profit can be made from information based trading. This leads to a random walk where the more efficient the market, the more random the sequence of price
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Different scholars have given different definitions for behavioral finance. According to Shefrin (2001), behavioral finance is the study of how psychology affects financial decision making processes and financial markets. Sewell (2007) defined it as the study of the influence of psychology on the behavior of financial practitioners and the subsequent effect on markets. It is of interest because it helps explain why and how markets might be inefficient. Behavioral finance is an attempt to explain and increase understanding of the reasoning patterns of investors, including the emotional processes involved and the degree to which they influence the decision-making process (Nyamolo,
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