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

Researchers find that, over 20 years, a portfolio of Indian stocks with the lowest price-to-book ratios earned higher average returns than a high price-to-book portfolio, even after adjusting for CAPM beta. Which interpretation is correct regarding tests of market efficiency?

The result is subject to the joint-hypothesis problem. Efficiency can only be tested together with an asset-pricing model, so excess returns after a CAPM adjustment may indicate market inefficiency or simply that CAPM omits relevant risk factors and is mis-specified.

  1. AIt is a joint-hypothesis problem: the result may show inefficiency or that the CAPM is a mis-specified model of required returnsCorrect
  2. BIt proves the market is strong-form inefficient
  3. CIt proves the market is weak-form efficient
  4. DIt is valid evidence only if beta is zero
  5. It shows that investors are risk-neutral

Explanation

Any test of efficiency requires a model of expected returns. An abnormal return measured against CAPM may arise from a wrong model (for example missing risk factors) rather than from inefficiency. Hence only the joint hypothesis is tested.

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