Working Paper: NBER ID: w2533
Authors: Bruce N. Lehmann
Abstract: Much of the theoretical basis for current monetary and financial theory rests on the economic efficiency of financial markets. Not surprisingly, considerable effort has been expended to test the efficient markets hypothesis, usually by examination of the predictability of equity returns. Unfortunately, there are two competing explanations of the presence of such predictable variation: (1)market inefficiency, and stock price 'overreaction' due to speculative 'fads' and (2) predictable changes in expected security returns associated with forecasted changes in market or individual security 'fundamentals?. These explanations can be distinguished by examining equity returns over short time intervals since there should be negligible systematic changes in the fundamental valuation of individual firms over intervals like a week in an efficient market. This study finds sharp evidence of market inefficiency in the form of systematic tendencies for current 'winners' and 'losers' in one week to experience sizeable return reversals over the subsequent week in a way that reflect apparent arbitrage profits. These measured arbitrage profits persist after corrections for the mismeasurement of security returns because of thin trading and bid-ask spreads and for plausible levels of transactions costs.
Keywords: Market Efficiency; Arbitrage; Equity Returns
JEL Codes: G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| predictable variations in equity returns (G12) | market inefficiency (G14) |
| systematic return reversals (G12) | market inefficiency (G14) |
| current winners and losers (D44) | significant return reversals (G14) |
| costless portfolios (G11) | zero profits (D41) |
| overreaction to information (D80) | systematic return patterns (G12) |
| portfolios of past winners (G11) | negative returns (G12) |
| portfolios of past losers (G11) | positive returns (G12) |