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IAI Actuarial Core Principles · Economic Modelling · Rational expectations theory and the efficient markets hypothesis

A researcher tests whether an investment strategy beats the market by comparing its returns with those predicted by the CAPM. The strategy earns a significant positive alpha. Why is it difficult to conclude definitively that the market is inefficient?

The test is a joint test of market efficiency and the asset pricing model used. A positive alpha may mean prices are inefficient, or it may mean the CAPM omitted relevant risk factors and so mismeasured expected return. The two explanations cannot be separated, which is the joint hypothesis problem.

  1. ABecause alpha is always zero by definition under CAPM
  2. BBecause the test of market efficiency is a joint test of efficiency and the asset pricing model usedCorrect
  3. CBecause the CAPM only applies to bonds
  4. DBecause efficient markets forbid any positive returns
  5. Because alpha can only be measured with insider information

Explanation

Abnormal returns are measured relative to an expected-return model. A positive alpha may reflect market inefficiency or a misspecified model, such as omitted risk factors. This is the joint hypothesis problem.

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