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The Dynamics Of Equity Prices In Fallible Markets

Bossaerts, Peter (1997) The Dynamics Of Equity Prices In Fallible Markets. Social Science Working Paper, 1015. California Institute of Technology , Pasadena, CA. (Unpublished)

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In an efficient securities market, prices correctly reflect news about future payoffs. This paper argues that there are two aspects to correctness: (i) correct updating of beliefs from news, (ii) correct prior beliefs. Traditionally, empirical research has implicitly insisted on both. Lucas' rational expectations equilibrium theory also assumes both, explicitly. Nevertheless, rationality requires only the former, but not the latter. This paper develops restrictions on the random behavior of prices of equity-like contracts when (i) is maintained, but the market may have mistaken priors about the likelihood of the bankruptcy state, in violation of (ii). The restrictions are cast in the form of familiar martingale difference results. They do not necessarily restrict returns as traditionally computed, however. Most importantly, the restrictions appear only when the empiricist deliberately imposes a selection bias. In particular, the price histories of securities that are in the money at the terminal date are to be separated from those of securities that end out of the money (i.e., in the bankruptcy state). As a result, this paper also demonstrates that something can be learned about market efficiency from samples subject to survivorship bias or the Peso problem.

Item Type:Report or Paper (Working Paper)
Bossaerts, Peter0000-0003-2308-2603
Additional Information:Revised version. First version dated to April 1995. This paper is a revision of Bossaerts [1996]. The first part came out of a sketchy paper that the author presented at the Université des Sciences Sociales, Toulouse, in April 1995, while he was at CentER, Tilburg University. He is grateful for the many comments from the seminar participants. In addition, the paper benefited through discussions at seminars at Carnegie Mellon University, U.C. Riverside (Economic Theory and Econometrics), University of Minnesota, Washington University at Saint Louis, the 1996 Asset Pricing summer meeting at NBER, the 1996 European Meetings of the Econometric Society, and through comments from and discussions with Oleg Bondarenko, David Easley, Alan Kraus, Guy Laroque, P.C.B. Phillips, Richard Roll and Philippe Weil. Oleg Bondarenko provided able research assistance. Ravi Jagannathan, the Executive Editor, and a referee provided invaluable comments and suggestions. The usual disclaimer applies.
Group:Social Science Working Papers
Subject Keywords:Market Efficiency, Incomplete Information, Biased Priors, Rational Learning, Martingales, Default, Survivorship Bias, Peso Problem
Series Name:Social Science Working Paper
Issue or Number:1015
Classification Code:JEL: C22, D84, G14
Record Number:CaltechAUTHORS:20170814-140850379
Persistent URL:
Usage Policy:No commercial reproduction, distribution, display or performance rights in this work are provided.
ID Code:80371
Deposited By: Jacquelyn Bussone
Deposited On:15 Aug 2017 16:25
Last Modified:03 Oct 2019 18:30

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