Market Efficiency, Rational Expectations, and Estimation Risk

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