Abstract
Empirical findings suggest that stock prices are overly volatile. The purpose of this study is to examine whether the observed level of stock price volatility can be explained by parameter uncertainty. Based on the simple efficient markets hypothesis, a restriction on the variance of the innovation in stock price is tested. This restriction compares the innovation variance of actual stock price to that of a naive forecast based on a Bayesian updating rule. Using CRSP stock price and dividend series, the bound is violated, indicating that time-varying parameters may not explain the excess volatility of stock price.
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