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

A share's price follows a process where price changes are independent of past changes and the expected return equals the required return. Researchers test this by regressing today's return on yesterday's return for a large sample of Nifty stocks. Under weak form efficiency, which result is expected?

Under weak form efficiency, yesterday's return should have no predictive power for today's return, so the regression slope should be statistically indistinguishable from zero. A significant slope would indicate exploitable serial correlation, contradicting the weak form of the efficient markets hypothesis.

  1. AA slope coefficient not significantly different from zeroCorrect
  2. BA significantly positive slope, showing momentum that can be exploited
  3. CA significantly negative slope with a large R-squared that can be exploited
  4. DAn intercept equal to the previous day's price
  5. A slope exactly equal to one

Explanation

If past returns carry no exploitable information, serial correlation should be zero, so the slope should be statistically indistinguishable from zero. A significant positive or negative slope with exploitable predictive power would contradict weak form efficiency. A slope of one would mean today's return simply repeats yesterday's.

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