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A Relationship Between Regression Tests and Volatility Tests of Market ncy

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  • Jeffrey A. Frankel
  • James H. Stock

Abstract

Volatility tests are an alternative to regression tests for evaluating the joint null hypothesis of market efficiency and risk neutrality. Acomparison of the power of the two kinds of tests depends on what the alternative hypothesis is taken to be. By considering tests based on conditional volatility bounds, we show that if the alternative is that one could"beat the market" using a linear combination of known variables, then the regression tests are at least as powerful as the conditional volatility tests.If the application is to spot and forward markets, then the most powerful conditional volatility test turns out to be equivalent to the analogous regression test in terms of asymptotic power. In other applications,the volatility test will be less powerful than regression tests against our chosen alternative. However, these results are not inconsistent with the observation that volatility tests may be more powerful against other alternative hypoth-eses, such as that risk-averse investors are rationally maximizing the present discounted utility of future consumption,with a time-varying discount rate.

Suggested Citation

  • Jeffrey A. Frankel & James H. Stock, 1983. "A Relationship Between Regression Tests and Volatility Tests of Market ncy," NBER Working Papers 1105, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:1105
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    1. Shiller, Robert J, 1981. "The Use of Volatility Measures in Assessing Market Efficiency," Journal of Finance, American Finance Association, vol. 36(2), pages 291-304, May.
    2. Shiller, Robert J, 1981. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," American Economic Review, American Economic Association, vol. 71(3), pages 421-436, June.
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    5. LeRoy, Stephen F & LaCivita, C J, 1981. "Risk Aversion and the Dispersion of Asset Prices," The Journal of Business, University of Chicago Press, vol. 54(4), pages 535-547, October.
    6. Richard Meese & Kenneth J. Singleton, 1980. "Rational expectations, risk premia, and the market for spot and forward exchange," International Finance Discussion Papers 165, Board of Governors of the Federal Reserve System (U.S.).
    7. LeRoy, Stephen F & Porter, Richard D, 1981. "The Present-Value Relation: Tests Based on Implied Variance Bounds," Econometrica, Econometric Society, vol. 49(3), pages 555-574, May.
    8. Lawrence H. Summers, 1982. "Do We Really Know That Financial Markets Are Efficient?," NBER Working Papers 0994, National Bureau of Economic Research, Inc.
    9. Flood, Robert P., 1981. "Explanations of exchange-rate volatility and other empirical regularities in some popular models of the foreign exchange market," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 15(1), pages 219-249, January.
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    11. Shiller, Robert J, 1979. "The Volatility of Long-Term Interest Rates and Expectations Models of the Term Structure," Journal of Political Economy, University of Chicago Press, vol. 87(6), pages 1190-1219, December.
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    Cited by:

    1. Mankiw, N Gregory & Romer, David & Shapiro, Matthew D, 1985. "An Unbiased Reexamination of Stock Market Volatility," Journal of Finance, American Finance Association, vol. 40(3), pages 677-687, July.
    2. Luigi Guiso & Paola Sapienza & Luigi Zingales, 2009. "Cultural Biases in Economic Exchange?," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 124(3), pages 1095-1131.
    3. Erwin W. Heri, 1986. "Irrationales rational gesehen: Eine Übersicht über die Theorie der "Bubbles"," Swiss Journal of Economics and Statistics (SJES), Swiss Society of Economics and Statistics (SSES), vol. 122(II), pages 163-186, June.

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