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Volatility Tests and Efficient Markets: A Review Essay

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  • John H. Cochrane

Abstract

This essay examines what volatility tests tell us about the data and what implications we should derive from them. It argues that volatility tests do not tell us that "prices are too volatile", implying that "markets are inefficient", but rather that "(discounted) returns are forecastable", implying that "current discount rate models leave a residual". It also argues that the discount rate residuals documented by volatility tests (and equivalent return forecasting regressions or Euler equation tests) are suggestive of rational, business cycle-induced discount rate movements, rather than "fads" or other inefficiencies.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 3591.

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Date of creation: Jan 1991
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Publication status: published as Journal of Monetary Economics, Vol. 27, pp.463-485, (1991).
Handle: RePEc:nbr:nberwo:3591

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  1. N. Gregory Mankiw & David H. Romer & Matthew D. Shapiro, 1989. "Stock Market Forecastability and Volatility: A Statistical Appraisal," NBER Working Papers 3154, National Bureau of Economic Research, Inc.
  2. Hamilton, James D. & Whiteman, Charles H., 1985. "The observable implications of self-fulfilling expectations," Journal of Monetary Economics, Elsevier, vol. 16(3), pages 353-373, November.
  3. John H. Cochrane, 1992. "Explaining the Variance of Price Dividend Ratios," NBER Working Papers 3157, National Bureau of Economic Research, Inc.
  4. Flood, Robert P & Hodrick, Robert J, 1990. "On Testing for Speculative Bubbles," Journal of Economic Perspectives, American Economic Association, vol. 4(2), pages 85-101, Spring.
  5. Poterba, James M. & Summers, Lawrence H., 1988. "Mean reversion in stock prices : Evidence and Implications," Journal of Financial Economics, Elsevier, vol. 22(1), pages 27-59, October.
  6. Grossman, Sanford J, 1981. "An Introduction to the Theory of Rational Expectations under Asymmetric Information," Review of Economic Studies, Wiley Blackwell, vol. 48(4), pages 541-59, October.
  7. Hansen, Lars Peter & Singleton, Kenneth J, 1982. "Generalized Instrumental Variables Estimation of Nonlinear Rational Expectations Models," Econometrica, Econometric Society, vol. 50(5), pages 1269-86, September.
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