Testing Market Efficiency With the Pricing Kernel
European Journal of Finance, 2019
45 Pages Posted: 1 Aug 2019 Last revised: 2 Jan 2020
Date Written: January 30, 2019
Market efficiency and the pricing kernel are closely related. A non-monotonic decreasing pricing kernel implies the existence of a trading strategy in contingent claims that stochastically dominates a direct investment in the market. Moreover, a market is assumed to be efficient only if no dominating strategies exist. Empirically, many studies of the pricing kernel find non-monotonicity, apparently ruling out market efficiency. However, these results are often unreliable, because the pricing measures of the pricing kernel are estimated using differing filtration sets. We show this effect both theoretically and empirically, and we discuss recent approaches in the literature for achieving more reliable estimates of the pricing kernel, potentially leading to better tests of market efficiency.
Keywords: market information; market efficiency; pricing kernel; fundamental theorems of asset pricing; dominating trading strategies
JEL Classification: G12; G13; G14
Suggested Citation: Suggested Citation