Market Efficiency, Rational Expectations, and Estimation Risk

47 Pages Posted: 16 Aug 1998

See all articles by Jonathan Lewellen

Jonathan Lewellen

Dartmouth College - Tuck School of Business; National Bureau of Economic Research (NBER)

Jay A. Shanken

Emory University - Goizueta Business School; National Bureau of Economic Research (NBER)

Date Written: June 1998

Abstract

In asset pricing, estimation risk refers to investor uncertainty about the parameters of the return or cashflow process. We show that estimation risk can significantly affect the time-series and cross-sectional behavior of asset prices. In particular, parameter uncertainty will tend to induce price reversals and negative serial correlation in returns. Prices can violate familiar 'volatility bounds' when investors are rational. Cross-sectionally, expected returns deviate from the CAPM even if investors attempt to hold mean-variance efficient portfolios, and these deviations will be predictable based on past dividends, prices, and returns. In short, we argue that estimation risk is likely to be important for characterizing an efficient market.

JEL Classification: C11, D83, G12, G14

Suggested Citation

Lewellen, Jonathan W. and Shanken, Jay A., Market Efficiency, Rational Expectations, and Estimation Risk (June 1998). Available at SSRN: https://ssrn.com/abstract=100828 or http://dx.doi.org/10.2139/ssrn.100828

Jonathan W. Lewellen (Contact Author)

Dartmouth College - Tuck School of Business ( email )

Hanover, NH 03755
United States
603-646-8650 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Jay A. Shanken

Emory University - Goizueta Business School ( email )

1300 Clifton Road
Atlanta, GA 30322-2722
United States
404-727-4772 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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