Chapter 42 Asset Pricing
Section snippets
What the Theory Predicts
A major evolution in the theory of asset pricing took place over the last century.
- (a)
In 1900, Bachelier suggested the random walk hypothesis: price changes ought not to be predictable from past information (see Bachelier, 1900). In the 1960s and 1970s, this theory became known as the efficient markets hypothesis (Fama, 1970),1
The Empirical Question
Which of these two theories provides the more appropriate view of the workings of financial markets: the relatively agnostic random walk theory or the more stylized equilibrium asset pricing models?
To compare the two theories, one could search for violations of the random walk hypothesis (if any can be found) and prove that these violations can be understood in light of equilibrium asset pricing models.
In field studies, it is customary to reject the random walk theory by identifying drift in
What the Field Data Teach Us
There is plenty of evidence that it is hard to predict asset price changes, in support of the random walk theory. Still, there are well-documented violations (a number of them are reported in Lo and MacKinlay, 1999). Granted, the amount of predictability that is present in the field data is small, but they do not seem to be compensation for risk in any way equilibrium asset pricing models predict. Best known is the finding in Fama and French (1992) that the historical drift in prices across
What the Experiments Teach Us
Experiments make it easier to identify the forces of equilibrium asset pricing theory, because almost all parameters can be controlled (e.g., aggregate wealth, market portfolio, expectations).2
Figure 1 displays the evolution of transaction prices in a typical asset pricing experiment. Subjects were allocated three securities, two of which were risky. The payoff on
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