Working Paper: CEPR ID: DP3593
Authors: Allan G. Timmermann; Clive Granger
Abstract: The efficient market hypothesis gives rise to forecasting tests that mirror those adopted when testing the optimality of a forecast in the context of a given information set. However, there are also important differences arising from the fact that market efficiency tests rely on establishing profitable trading opportunities in ?real time?. Forecasters constantly search for predictable patterns and affect prices when they attempt to exploit trading opportunities. Stable forecasting patterns are therefore unlikely to persist for long periods of time and will self-destruct when discovered by a large number of investors. This gives rise to nonstationarities in the time series of financial returns and complicates both formal tests of market efficiency and the search for successful forecasting approaches.
Keywords: efficient market hypothesis; forecast evaluation; learning; model specification
JEL Codes: G00
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| search for predictable patterns by forecasters (C53) | price adjustments in the market (D41) |
| many forecasters attempt to exploit trading opportunities (G17) | stable forecasting patterns self-destruct (C53) |
| recognition of stable forecasting patterns by significant number of investors (G17) | nonstationarities in the time series of financial returns (C22) |
| nonstationarities in the time series of financial returns (C22) | complications in formal tests of market efficiency (G14) |
| nonstationarities in the time series of financial returns (C22) | complications in the search for successful forecasting methods (C53) |