A History of British Actuarial Thought by Craig Turnbull

Author:Craig Turnbull
Language: eng
Format: epub
Publisher: Springer International Publishing, Cham

Market Efficiency

Our discussion of the emergence of key ideas in financial economics has focused mainly on the development of economic theories. That is, a range of theoretical results have been discussed (for example, the Capital Asset Pricing Model) that have been developed deductively from a set of starting axioms (investor risk aversion and non-satiation, and so forth). In all cases, these results were subject to various forms of empirical testing, and such testing has consistently formed a substantial part of financial economics’ research output. But this final section is somewhat different in that it is related to a stream of work that is intrinsically empirical: it is focused first and foremost on how well ‘real-life’ financial markets work—not in theory, but in practice. In particular, this stream of financial economics considers the informational efficiency of financial markets’ prices. Pricing efficiency in this context refers to how well market prices reflect relevant information and how quickly prices react to new information. Its empirical nature and its implications for the possible lack of usefulness of large swathes of financial services practitioners have made it one of the most contentious areas of financial economics. This was true many decades ago and it remains true today, particularly as later research has painted a more complex and nuanced picture of real-life market behaviour than that implied by market efficiency’s major research results of the 1960s and early 1970s.

We noted some detailed empirical studies of stock price behaviour in the discussion of option pricing theory—in particular, Osborne’s 1959 research that provided an empirical basis for the use of geometric Brownian motion as a reasonable model of stock price behaviour. There are also some earlier examples of empirical research that date back to the first half of the twentieth century. But improvements in the collation of security price data and growing computing power stimulated a new wave of empirical analysis of security prices in the 1950s.

Besides Osborne, another important example of this empirical work was provided by Maurice Kendall, who was director of research techniques at the London School of Economics. Kendall presented a detailed empirical study of the time series behaviour of financial market prices to the Royal Statistical Society in 1952.52 The study provided the most detailed statistical analysis to date of the time series behaviour of stock prices. Kendall considered UK equity market behaviour over the ten-year period between 1928 and 1938, and wheat prices on the Chicago Board of Trade between 1883 and 1934. In both cases he could find little evidence of statistically significant serial correlations at any time-lag. As a trained economist with a faith in rational market responses to the business cycle, this lack of trend or apparent signal in the price process confused and alarmed Kendall:At first sight, the implications are disturbing … it seems that the change in price from one week to the next is practically independent of the change from that week to the week after. This alone is enough to show that it is impossible

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