Working Paper: NBER ID: w2762
Authors: Stephen C. Cecchetti; Poksang Lam; Nelson C. Mark
Abstract: Recent empirical studies have found that stock returns contain substantial negative serial correlation at long horizons. We examine this finding with a series of Monte Carlo simulations in order to demonstrate that it is consistent with an equilibrium model of asset pricing. When investors display only a moderate degree of risk aversion, commonly used measures of mean reversion in stock prices calculated from actual returns data nearly always lie within a 60 percent confidence interval of the median of the Monte Carlo distributions. From this evidence, we conclude that the degree of serial correlation in the data could plausibly have been generated by our model.
Keywords: mean reversion; asset pricing; stock returns; market efficiency
JEL Codes: G12; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Empirically estimated serial correlation of stock returns (C22) | Consistent with an equilibrium model of asset pricing (G19) |
| Negative serial correlation (C22) | Does not necessarily imply market inefficiency (G14) |
| Degree of risk aversion among investors (D81) | Affects the serial correlation observed in returns (C22) |
| Moderate risk aversion (D11) | Leads to mean reversion (C22) |
| Small sample bias (C83) | Contributes to the observed serial correlation in actual returns (C22) |