Market Efficiency's Hidden Teeth: An Unambiguous Test for Derivative Securities

34 Pages Posted: 13 Jun 2005

See all articles by Zachary R. Nye

Zachary R. Nye

Stanford Consulting Group

Timothy C. Johnson

London Business School; University of Illinois

Date Written: June 2005

Abstract

Over the last decade, financial economists have grown increasingly circumspect about the practical meaning of market efficiency due to the so-called joint hypothesis problem. In law, however, the concept has taken on an increasingly prominent role, meaning that the need for an operational definition cannot wait. We examine the meaning of market efficiency in contingent claims markets, where existing legal criteria are inappropriate. We propose a practical and economically meaningful test of efficiency applicable to such markets. The test is shown to be immune both to the joint hypothesis problem and to misspecification of the derivatives pricing model. We illustrate application of the test to an important recent case involving credit-linked notes.

Keywords: Market efficiency, derivatives, litigation

JEL Classification: G13, G14, K22, K41

Suggested Citation

Nye, Zachary R. and Johnson, Tim and Johnson, Tim, Market Efficiency's Hidden Teeth: An Unambiguous Test for Derivative Securities (June 2005). Available at SSRN: https://ssrn.com/abstract=742567 or http://dx.doi.org/10.2139/ssrn.742567

Zachary R. Nye

Stanford Consulting Group ( email )

161 North Broad Street
Woodbury, NJ 08096
United States

Tim Johnson (Contact Author)

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

University of Illinois ( email )

601 E John St
Champaign, IL Champaign 61820
United States

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