Working Paper: NBER ID: w2890
Authors: Charles Engel; Jeffrey A. Frankel; Kenneth A. Froot; Anthony Rodriguez
Abstract: We apply the method of constrained asset share estimation (CASE) to test the mean-variance efficiency (MVE) of the stock market. This method allows conditional expected returns to vary in unrestricted ways, given investor preferences. We also allow conditional variances to follow an ARCH process. The data estimate reasonably the coefficient of relative risk aversion, though are unable to reject investor risk neutrality. We reject the restrictions implied by MVE, although changing conditional variances improve statistically upon measured market efficiency. We find that unrestricted asset-share and ARCH models help forecast excess returns. Once MVE is imposed, however, this forecasting ability disappears.
Keywords: Mean-variance efficiency; Stock market; Asset pricing; ARCH process
JEL Codes: G12; C32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Asset shares (G12) | Monthly excess stock returns (G12) |
| Conditional variances (C29) | MVE frontier (F12) |
| Higher conditionally expected returns (G19) | Lower value shares (G12) |
| ARCH process (C22) | Conditional variances (C29) |
| MVE hypothesis rejection (C52) | Market efficiency (G14) |