Abstract
Excess volatility tests for financial market efficiency maintain the hypothesis of risk neutrality. This permits the specification of the benchmark efficient market price as the present discounted value of expected future dividends. By departing from the risk neutrality assumption in a stripped-down version of Lucas's general equilibrium asset pricing model, I show that asset prices determined in a competitive asset market and efficient by construction can nevertheless violate the variance bounds established under the assumption of risk neutrality. This can occur even without the problems of non-stationarity (including bubbles) and finite samples. Standard excess volatility tests are joint tests of market efficiency and risk neutrality. Failure of an asset price to pass the test may be due to the absence of risk neutrality rather than to market inefficiency.
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