Estimation Risk, Market Efficiency, and the Predictability of Returns
49 Pages Posted: 19 Dec 2000
Date Written: August 2000
In asset pricing, estimation risk refers to investor uncertainty about the parameters of the return or cashflow process. We show that, with estimation risk, the empirical properties of prices and returns can differ significantly from the properties perceived by rational investors. As a consequence, parameter uncertainty will tend to induce return predictability in ways that resemble irrational mispricing, prices can violate familiar volatility bounds even if discount rates are constant, and expected returns can deviate from the CAPM when investors attempt to hold mean-variance efficient portfolios. In short, estimation risk can be important for characterizing and testing market efficiency.
JEL Classification: C11, D83, G12, G14
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