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Actual and Warranted Relations Between Asset Prices

Efficient markets models assert that the price of each asset is equal to the optimal forecast of its ex-post or fundamental value. These models do not imply, however, that the covariance between two asset prices is given by the covariance between the ex-post values they respectively forecast: these two covariances can even have opposite signs. However, it is possible to place bounds on the covariance between asset prices given the covariance matrix of ex-post values. We present such bounds for both covariances and correlations and show how such bounds can be tightened using information beyond the covariance matrix of ex-post values. The methods are used to examine whether the historical correlation between the U.S. and U.K. stock markets 1919-1989 is warranted. The bounds on the warranted covariance are very wide and include the actual correlation.

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File URL: http://cowles.yale.edu/sites/default/files/files/pub/d09/d0970.pdf
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Paper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 970.

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Length: 22 pages
Date of creation: Feb 1991
Publication status: Published in Oxford Economic Papers (1993), 45: 387-402
Handle: RePEc:cwl:cwldpp:970
Note: CFP 859.
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  1. King, Mervyn A & Wadhwani, Sushil, 1990. "Transmission of Volatility between Stock Markets," Review of Financial Studies, Society for Financial Studies, vol. 3(1), pages 5-33.
  2. Shiller, Robert J. & Beltratti, Andrea E., 1992. "Stock prices and bond yields : Can their comovements be explained in terms of present value models?," Journal of Monetary Economics, Elsevier, vol. 30(1), pages 25-46, October.
  3. Robert S. Pindyck & Julio J. Rotemberg, 1990. "Do Stock Prices Move Together Too Much?," NBER Working Papers 3324, National Bureau of Economic Research, Inc.
  4. Shiller, Robert J, 1989. " Comovements in Stock Prices and Comovements in Dividends," Journal of Finance, American Finance Association, vol. 44(3), pages 719-729, July.
  5. Pindyck, Robert S & Rotemberg, Julio J, 1990. "The Excess Co-movement of Commodity Prices," Economic Journal, Royal Economic Society, vol. 100(403), pages 1173-1189, December.
  6. King, Mervyn & Sentana, Enrique & Wadhwani, Sushil, 1994. "Volatility and Links between National Stock Markets," Econometrica, Econometric Society, vol. 62(4), pages 901-933, July.
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