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Methodological issues in asset pricing: Random walk or chaotic dynamics

In: Economic Uncertainty, Instabilities And Asset Bubbles Selected Essays

Listed author(s):
  • A. G. Malliaris

    (Department of Economics, Loyola University, 820 N. Michigan Avenue, Chicago, IL 60611, USA)

  • Jerome L. Stein

    (Division of Applied Mathematics, Brown University, Box F, Providence, RI 02912, USA)

AbstractWe analyze the theoretical foundations of the efficient market hypothesis by stressing the efficient use of information and its effect upon price volatility. The "random walk" hypothesis assumes that price volatility is exogenous and unexplained. Randomness means that a knowledge of the past cannot help to predict the future. We accept the view that randomness appears because information is incomplete. The larger the subset of information available and known, the less emphasis one must place upon the generic term randomness. We construct a general and well accepted intertemporal price determination model, and show that price volatility reflects the output of a higher order dynamic system with an underlying stochastic foundation. Our analysis is used to explain the learning process and the efficient use of information in our archetype model. We estimate a general unrestricted system for financial and agricultural markets to see which specifications we can reject. What emerges is that a system very close to our archetype model is consistent with the evidence. We obtain an equation for price volatility which looks a lot like the GARCH equation. The price variability is a serially correlated variable which is affected by the Bayesian error, and the Bayesian error is a serially correlated variable which is affected by the noisiness of the system. In this manner we have explained some of the determinants of what has been called the "randomness" of price changes.

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This chapter was published in:
  • A G Malliaris, 2005. "Economic Uncertainty, Instabilities and Asset Bubbles:Selected Essays," World Scientific Books, World Scientific Publishing Co. Pte. Ltd., number 5864, June.
  • This item is provided by World Scientific Publishing Co. Pte. Ltd. in its series World Scientific Book Chapters with number 9789812701015_0008.
    Handle: RePEc:wsi:wschap:9789812701015_0008
    Contact details of provider: Web page: http://www.worldscientific.com/page/worldscibooks

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    1. Baumol, William J & Benhabib, Jess, 1989. "Chaos: Significance, Mechanism, and Economic Applications," Journal of Economic Perspectives, American Economic Association, vol. 3(1), pages 77-105, Winter.
    2. Kandel, Eugene & Pearson, Neil D, 1995. "Differential Interpretation of Public Signals and Trade in Speculative Markets," Journal of Political Economy, University of Chicago Press, vol. 103(4), pages 831-872, August.
    3. Stein, Jerome L, 1992. "Price Discovery Processes," The Economic Record, The Economic Society of Australia, vol. 0(0), pages 34-45, Supplemen.
    4. Stein, Jerome L, 1992. "Cobwebs, Rational Expectations and Futures Markets," The Review of Economics and Statistics, MIT Press, vol. 74(1), pages 127-134, February.
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