Abstract
A linear return generating model is introduced. This model is a generalization in discrete time of the differential equation describing dynamical systems in continuous time. The model is useful in its own right, as it provides a simplified, yet credible, quantitative description of the reality. Further, the model is used as a tool for a theoretical study of market efficiency testing. This is obtained by modelling certain market conditions under which new information is released and reflected in asset prices on the one hand, and, on the other hand, by recording what established econometric testing approaches conclude, about the hypothesis of market efficiency. Amongst others it is argued that, contrary to the general belief, theoretically a random walk in asset prices, under certain conditions, could be associated with profoundly inefficient markets. Furthermore, an enhancement of the battery of statistical tests for market efficiency is proposed by the potential application of specific forms of the suggested linear dynamic model and the possible advantages over the existing techniques are explained. Finally, market efficiency is discussed in its relation to Technical Analysis.
Highlights
This was possibly among the reasons for which Fama [9] suggested some changes in the terminology and coverage for the three classes of market efficiency: instead of weak-form tests he suggested the more general tests for “return predictability”, which, in addition to past returns, host tests which may include variables related to firm characteristics, market characteristics and the time of the year
Some of the reasons may be the following: 1) the borderline between the information sets of the first and the second category in the revised taxonomy was somewhat unclear; 2) as, unquestionably, tests in all categories refer to return predictability, it is apparently wrong to use this term for the first category only; 3) though SSFME clearly entails WFME, there is a less clear ordering between the categories “event studies” and “return predictability”
This mechanism is a simplification of reality, but it can make a useful tool for an assessment of market efficiency testing approaches
Summary
Implications and Potential Applications for Market Efficiency Testing and Technical Analysis.
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