Testing Efficiency in Small and Large Financial Markets

Abstract

We investigate practical tests of market efficiency that are not subject to the joint-hypothesis problem inherent in tests that require the specification of an equilibrium model of asset prices. The methodology we propose simplify the testing procedure considerably by reframing the market efficiency question into one about the existence of a local martingale measure. As a consequence, the need to directly verify the no dominance condition is completely avoided. We also investigate market efficiency in the large financial market setting with the introduction of notions of asymptotic no dominance and market efficiency that remain consistent with the small market theory. We obtain a change of numeraire characterization of asymptotic market efficiency and suggest empirical tests of inefficiency in large financial markets.