Predictability of asset returns

Are financial asset prices predictable? Any answer to this question is closely connected to another
important question in financial economics, are financial markets efficient? In an efficient market,
prices of assets wander or walk in an unpredictable or in a random manner. If so, any abnormal se-
curity return is unforecastable, hence random, and the hypothesis of market efficiency is not rejected.
Thus empirical tests of random walks can provide insights into issues of market efficiency. One simple
way to conduct such tests is by using past information only, even though more sophisticated models
of asset prices can give better answers. This is sometimes called the weak-form efficiency. Though
restrictive, forecasts based on past information alone still offer some rich insights to our question
and is an area of active empirical research. Restrictive because, models like the multi-factor pricing
models, capital asset pricing models (CAPM), use additional economic variables to construct fore-
casts and are certainly more popular. However, in this module we shall take the simpler route and
review the various versions of random walk hypothesis, including the variance ratio tests and also on
long-horizon returns.
The earliest financial asset price model was the martingale model. A martingale is a stochastic
process {Pt } which satisfies the following condition:

E[Pt+1 |Pt , Pt1 , ] = Pt

or equivalently,

E[Pt+1 Pt |Pt , Pt1 , ] = 0

According to this definition, the best one-period forecast of prices is simply todays price. How-
ever, this definition says something about only first moment and not the higher moments. This
embodies the notion of a fair game. If Pt presents cumulative winnings or wealth at date t from
a game of chance each period, then a fair game is when the expected wealth next period is simply
equal to this periods wealth conditioned on the history of the game. From a forecasting perspective
the martingale hypothesis implies that if Pt is taken to be an assets price at date t, then the best
forecast of tomorrows price is simply todays price, best in the sense it is the minimum mean squared
error (MMSE), given the assets entire pricing history. Note that this property uses only the first
moment, the mean and not any higher moments. Second, it is defined on the non-overlapping price
changes, implying that linear forecasting of future price changes based on past price changes is ruled
out.

1
 Samuelson calls this martingale model as weak form efficiency. Since todays price reflects all
past information, it is not possible to make profits using past price information. However, it was
later recognised that there was a trade off between risk and expected returns, and a risk premium is
necessary to attract investors to bear the risk. This resulted in weaker forms of efficiency hypothesis
and random walk concepts.
-
Example 1: Halls Martingale with consumption
Let Zt be a vector containing a set of macroeconomic variables, including consumption, ct , for
period t. According to Hall (JPE,1978,86,987), consumption is a martingale, with respect to Zt :

E(ct |Zt1 , Zt2 , . . . , Z1 ) = ct1

This concept formalizes the concept of consumption smoothing that is consumer wanting to
avoid fluctuations in consumption, adjusts consumption in t 1 to a level, such that no change in
subsequent consumption is anticipated.
Example 2: Naive inflation forecasts:
The best inflation forecast for the t+h using martingale model for inflation is the current inflation:

E(t+h |It ) = t

This simplest model outperformed many popular models, like the ARM A models or Phillips
curve
It is this idea of a martingale that was long considered to be a necessary condition for an efficient
asset market. It is market where the information contained in past prices is instantly, fully and
perpetually reflected in the assets current price. If it is so, then no one can profit by trading on
the information contained in the assets past prices; hence conditional expectation of future price
changes, conditional upon past history, cannot be either positive or negative. It is simply zero. Thus
the more efficient the market, the more random is the sequence of price changes and hence, a market
where price changes are completely random and unpredictable, is the most efficient market.
Though it was subsequently shown in the literature that martingale property is neither a necessary
nor a sufficient condition for a rationally determined asset prices, it led to the development of another
closely related model called the random walk hypothesis.
-

2
 Random walk hypothesis
There are several definitions of random walk. All definitions emphasize on the conditions that
explain the idea that prices wander in a random manner.
The random walk 1: IID increments
The simplest version of the random walk hypothesis is the independently and identically dis-
tributed (IID) increments in which the dynamics of the prices Pt is governed by the following equa-
tion:
Pt = + Pt1 + et , et IID(0, 2 ) [RW 1]

where is the expected price change or drift. Following recursive substitution, we can find the
conditional mean and variance, conditional on some initial value P0 , of RW1 as

E[Pt |P0 ] = P0 + t

var[Pt |P0 ] = t 2

It is clear that the random walk is nonstationary, as both the mean and variance or linear functions of
time. If we further assume that the distribution is normal, that is, et s are IID N (0, 2 ), it simplifies
many calculations but allow for the possibility that Pt < 0. So we normally assume that the natural
logarithm of prices, pt = logPt , follows a random walk with normally distributed increments, so that

pt = + pt1 + et et IID N (0, 2 )

This implies that continuously compounded returns are IID normal variates. Though a random walk
model can be considered as a special case of the fair game model, it is more restrictive than a fair
game model since it requires the returns to be IID. So a rejection of the null hypothesis of random
walk does not imply the market is inefficient.
Random walk 2: Independent Increments
The assumption of IID under RW1 is not a tenable over a large span of time. While analysing
the daily stock returns of the two-hundred year old New York stock exchange, it is difficult to justify
the IID assumption, since innumerable economic, political, economic and institutional changes have
taken place over this period. To expect that the probability laws governing the returns would have
remained the same may not get empirical support. So we relax the assumption of IID to allow for
independent but not identically distributed increments. And this can be called Random Walk 2
model or RW2. Thus we allow for unconditional heteroscedasticity in the es to vary, leading to a
Markov threshold model. So variance could have two states.

3
 Random walk 3: Uncorrelated Increments
An even more general version of random walk hypothesis the one most tested in the empirical
literature is obtained by relaxing the assumption of independent increments and include processes
that have dependent but uncorrelated increments. This may be called the Random Walk 3 model
or RW3. An example of such a process could be a one where cov(et , etk ) = 0 for all k 6= 0,
but cov(e2t , e2tk ) 6= 0 for some k 6= 0. Such processes have uncorrelated increments; but are not
independent because their squared increments are correlated. This resulted in a whole family of
ARCH models.

Tests of random walk 1: IID increments

Most of the earlier attempts to test the random walk hypothesis were about testing RW1 and
RW2. Though outdated, these tests enable us to understand the properties of long horizon returns
to be discussed later.

Sequences and Reversals

We shall use the logarithmic version of RW1, in which log prices pt follow an IID random walk
without drift:

pt = pt1 + et , et IID(0, 2 )

One of the first tests, proposed by Cowles and Jones (1937, Econometrica, 5, 280-294,) (CJ),
called the CJ-test, consisted of comparing the frequency of sequences and reversals in historical stock
returns. Sequences are pairs of consecutive returns with the same sign, and the reversals are pairs
of consecutive returns with opposite signs. That is,

A sequence is {rt , rt+1 } > 0 or {rt , rt+1 } < 0

A reversal is {rt > 0, rt+1 < 0} or {rt < 0, rt+1 > 0}.

The basic idea is to compare the observed number of sequences and reversals in the time series
of prices with the expected number of reversals and sequences under RW1. To enable that, define
the following indicator variable:

4

1 if rt pt pt1 > 0

It =
0 if rt pt pt1 0.

It is much like a fair-coin-tossing experiment and It indicates if the return in a particular period
is positive or negative. Note that It is a Bernoulli random variable with

= P (It = 1) = P (rt > 0)

1 = P (It = 0) = P (rt 0)

Further, note that under RW1, = 0.5. If we have a sample of n + 1 returns, r1 , , rn+1 , the
number of sequences is labeled Ns and reversals, Nr can be expressed as follows:

Yt = It It+1 + (1 It )(1 It+1 )

Xn
Ns = Yt
t=1
Nr = n Ns .

where

1,

if It = It+1 = 1, or It = It+1 = 0 sequence
Yt =
0,

if It = 1, It+1 = 0, or It = 0, It+1 = 1 reversal

Note that the indicator Yt indicating a sequence is also a Bernoulli random variable with,

s = P (Y = 1) = P (It = 1, It+1 = 1) + P (It = 0, It+1 = 0)

Hence under RW1 which implies serially independent rt s and It s, this probability for a sequence
hence has the form,

s = P (It = 1) P (It+1 = 1) + P (It = 0) P (It+1 = 0)

= 2 + (1 )2

and for a reversal,

1 s = 2(1 )

5
 This implies that, if the log prices follow a driftless random walk and et follows a symmetric
distribution, then whether rt will be positive or negative, should be equally likely. Or alternatively,
sequences and reversals should be equally likely. So the ratio, Ns /Nr should be approximately one.
Hence, CJ (1937) suggested the test statistic,

1
Pn
# sequences Ns n t=1 Yt
CJ =
c = = 1
P n .
# reversals n Ns 1 n t=1 Yt
The fact that this ratio exceeded one led early researchers like Cowles and Jones to conclude that
there may be some structure in stock prices. However, to conduct a test of the CJ-test, we need to
know the asymptotic distribution of the test. It can be shown that,

 
D s
CJ
c N , asy. var(CJ)
1 s
where
s (1 s ) + 2 [ 3 + (1 3 ) s2 ]
asy. var(CJ)
c =
n(1 s )4
The unknown parameters can be estimated by

n
1X

= It and 2 + (1 2 )2
s =
n t=1

However the assumption of driftless random walk is a critical assumption. If we allow for drift,
it is no more a fair-coin-tossing experiment. Rather it is more biased towards the direction of the
drift. Here we can consider the model,

pt = + pt1 + et , et IID(0, 2 )

Here the indicator variable is defined as follows:

1 with probability

It =
0 with probability 1 .

where


= Pr(rt > 0) = .

If the drift is positive then > 1/2 and if it is negative < 1/2. Under this general specification,
the ratio of s to 1 s is given as ,

6
 2 + (1 )2
CJ = 1
2(1 )
Suppose = 0.08 and = 0.21, then we get the following estimates:

 
0.08
= = 0.6484
0.21
2 + (1
s = )2 = 0.5440

CJ
c = 1.19

To comment on the significance of the estimator CJ

c one can however use the same asymptotic

distribution we obtained earlier for the driftless random walk model.

Runs Test
Another common test for RW1 is the runs test. It is a nonparametric test and has a long history.
The works of Mood, based on combinatorial experiments and that of and Wald and Wolfowitz are
popular testing methods. The latter propose runs test to check if two samples are from the same
population or to check the randomness of a sample of time series observations. In a runs test, the
number of sequences of consecutive positive and negative returns or runs, is tabulated and compared
against its sampling distribution under the random walk hypothesis. Suppose we have a sequence of
10 returns, 1001110100. This consists of three runs of 1s, of length 1, 3 and 1 respectively and three
runs of 0s, of length 2, 1 and 2 respectively, with 6 runs in total. On the other hand, a sequence of
0000011111 has the same number of 0s and 1s; but has only two runs.
Famas (1965, Journal of Business, pp.34-105) example is a simple one of runs test. Let us define
the following:


1

if return is positive

1 if qt 6= qt+1

qt = 0 if return is zero ct =


0 otherwise


1 if return is negative

The total number of runs of al types is

n1
X
C =1+ ct
t=1
Assuming that there the sample proportions of positive, negative, and zero price changes are
good estimates of the population proportions, then under the hypothesis of independence the total
expected number of runs of all signs for a stock can be computed as

7
 " 3
#
X
E(C) = m = n(n + 1) n2i /n
i=1

Similarly an expression for the variance of C, var(C) can be written. And for large n, the sampling
distribution of m is approximately normal so that, a test can be evaluating by defining

(C E(C))
m
= p
var(C)

RW1 can be rejected at the 5% level, if |m|

> 1.96.

Tests of random walk 2: Independent increments

The assumption of IID increments is of course totally implausible, especially if we are analysing
financial data that span several decades. However, relaxing the assumption of identical distributions
make the problem of testing for independence highly intractable. Nevertheless two lines of testing
called, the filter rules and technical analysis are very popular in the financial community. Since not
much use of formal statistical inference is made in these two approaches, we shall not spend much
time here.
Tests of random walk 3: Uncorrelated increments
Under this test we test random walk hypothesis by checking for serial correlation between two
observations at different dates. According to this weakest version of random walk, RW3, the first
differences of levels of the asset prices are expected to be uncorrelated at all leads and lags. So a
test of the hypothesis can be conducted by checking for the statistical significance of autocorrelation
coefficients at all leads and lags.
Let the kth order sample autocorrelations be estimated as

k
k =
0

where k is the estimated kth order autocovariance. Sampling theory for k depends on the process
that rt follows. Fuller shows, under the null that rt follows RW1, where k = 0 for all k > 0,
the sample autocorrelations k are negatively biased. So he suggests the following bias corrected
estimator:
T K
1 2k .


k = k + 2
(T 1)
With uniformly bounded sixth moments, Fuller then shows that, for a sample of size T, the
sample autocorrelation coefficients are asymptotically independent and normally distributed with

8
distribution,
T
k N (0, 1)
T k
.

Portmanteau statistics
Another test statistic to check that all autocorrelations are zero, is the finite sample corrected
statistic:
Box-Pierce Q statistic, called the Ljung-Box Q
K
= T (T + 2)
X 2k
Q
k=1
T k

This has power against a broad range of alternatives, though the selection of K requires some
care. Though such statistics are are useful, better tests of the random walk hypotheses may be
available when specific alternative hypothesis are identified. Variance ratios and the associated tests
are examples of such tests.
-
Variance Ratios
An important property of all three random walk hypotheses is that the variance of random walk
increments must be a linear function of the time interval. Let us assume as before pt = logPt , where
Pt is the stock price, we have,

pt = + pt1 + et , et IID N (0, 2 ) (V R 1)

Defining rt = pt pt1 the variance of rt + rt1 must be twice the variance of rt . Therefore the
plausibility of the random walk may be checked by comparing the variance of rt + rt1 to twice the
variance of rt . In practice this equality may not hold exactly, but a ratio involving these two quantities
must be statistically indistinguishable from one. Thus to conduct a statistical test of variance ratio,
we need to understand the statistical distribution of the variance ratio under the null of random walk
hypothesis.

9
 Population properties of variance ratios
Let us elaborate further on the concept of variance ratios. We shall start by assuming that the
rt s are stationary. Let the two period (continuously compounded) return be rt (2). The variance
ratio we are interested in can be explained as follows:
Var[rt (2)] Var[rt + rt1 ]
VR(2) = =
2 Var[rt ] 2 Var[rt ]
2 Var[rt ] + 2 Cov[rt , rt1 ]
=
2 Var[rt ]
= 1 + 1 (V R 2)

Thus for any stationary series, the variance ratio statistic, V R(2) is simply 1 + 1 .
But under random walk, all autocorrelations zero and hence V R(2) = 1 as expected. So in the
presence of first order correlation V R(2) will exceed one. If 1 is positive, then V R(2) which is the
variance of the sum of two one period returns will be larger than the sum of the one period returns
variances. And hence, variances will grow faster than linearly. Similarly, one can reason out, if 1
is positive, variances will grow slower than linearly. For comparisons beyond one and two period
returns higher-order autocorrelations come into play.
-
Let us generalize the above discussion for any q period return. When random walk is true, then

Var[rt (q)] = Var[rt + rt1 + + rtq+1 ]

= q Var[rt ]

so that
q Var[rt ]
V R(q) = = 1.
q Var[rt ]
What will this ratio be when random walk is not true? (That is, when rt is stationary.) We get

Var[rt (q)] = q Var[rt ] + all the covariance terms

so that we get the variance ratio as

Var[rt (q)]
V R(q) =
q Var[rt ]
q1
2X
= 1+ (q j) j (V R 3)
q j=1

What this shows is that V R(q) is a particular linear combination of the first q 1 autocorrelations
of [rt ], with linearly declining weights. This is easily seen by re-writing (V R 3) as
q1  
X j
V R(q) = 1 + 2 1 j (V R 4)
j=1
q

10
Under random walk, V R(q) = 1 because j = 0 for j 1.
Though many versions of variance ratio tests are discussed in the literature, we shall discuss below
two popular tests proposed by Lo and MacKinlay and Cochrane. We shall also discuss a test for
joint testing of the variance ratios, called the multiple variance ratio test in the literature. Though
many tests have been suggested for a joint testing of the variance ratios, we shall discuss only that
recommended by Chow and Dennings.
-
Sampling distribution of Vd
D(q) and V
d R(q) under RW1
Lo-MacKinlay test
Lo and MacKinlay (LM here after) recommend two different estimators, viz. the variance ratio
estimator,VR(q), and the variance difference estimator, VD(q), to test the null of RW1 and have
also provided the asymptotic distributions of these two estimators, under the null of random walk
with iid increments and heteroscedastic increments. We shall study these estimators below.
LM suggest checking the null of a random walk assuming initially that the increments, et s, are
identically and independently distributed. We begin by stating the null hypothesis.
Let pt denote the log-prices, and let rt = pt pt1 . The null hypothesis we consider is:

H0 : rt = + et , et IID N (0, 2 )

Note that normality is just a convenient assumption. The discussion that follows hold for any
IID increments, with finite fourth moments. Let the data contain 2N + 1 observations on log prices,
(p0 , p1 , . . . , p2N ) at equally paced intervals of time. Consider the following estimators for the unknown
parameters in the null hypothesis:
2N
1 X 1

= (pk pk1 ) = (p2N p0 ) (V R 5)
2N k=1 2N
2N
1 X
a2
= )2
(pk pk1 (V R 6)
2N k=1
N
1 X
b2 =
) 2
(p2k p2k2 2 (V R 7)
2N k=1

The estimators a2 correspond to the MLE of and a2 . To initiate the testing for variance
and
ratio, LM start by suggesting first, an estimator for the two period return, Var[rt (2)], which under H0
is nothing but Var(rt + rt1 ) = (1/2)Var(pt pt2 2) = 2 . Given this expression LM recommend
b2 , (V R 7) above, which is also a consistent estimator of 2 but inefficient
also another estimator,
because it uses only a subset of (N + 1) observations, p0 , p2 , p4 . . . , p2N and corresponds to formally

11
1/2 times the variance estimator for the increments of even numbered observations as noted above.
Under standard asymptotic theory, all these estimators are consistent and they posses the following
asymptotic distributions:

D
a2 2
2N N (0, 2 4 ) (V R 8)

D
b2 2
2N N (0, 4 4 ) (V R 9)

b2
But LM suggest another estimator, called the variance difference estimator, a2 = Vd
D(2). To
derive the asymptotic distribution of Vd
D(2) we make use of a result by Hausman. Hausman exploits
the fact that any asymptotically efficient estimator of a parameter , say e must posses the property
that it is asymptotically uncorrelated with the difference, a e , where a is any other admissible
consistent estimator of . If not, there exists a linear combination of e and a e that is more
efficient than e , contradicting the assumption of efficiency. Hence, we can write out the following
result:

Asy.Var [a ] = Asy.Var [e + a e ]

= Asy.Var [e ] + Asy.Var [a e ]

= Asy.Var [a e ] = Asy.Var [a ] Asy.Var [e ]

a2 is an asymptotically efficient
In the above result Asy.var refers to asymptotic variance. Since
estimator under the null, we may use the above result and say that the asymptotic variance of the
difference of a consistent estimator and an asymptotically efficient estimator is simply the difference
of the asymptotic variances. Hausmans result implies,
D
D(2)
2N Vd N (0, 2 4 ) (V R 10)

The null can be tested using (V R 10) by substituting any consistent estimator for 2 4 , say 2(
a2 )2 .
By constructing the normalized test statistic

2N Vd D(2) D
N (0, 1) (V R 11)
4
2
which has a limiting standard normal distribution, we reject the null of random walk, if the test
statistic Vd
D(2) lies outside the interval [1.96, +1.96].
One can find the asymptotic distribution of the two-period variance ratio test statistic, V R(2) =
b2 /
a2 , from (V R 10) using the delta method, as
 
D
2N VdR(2) 1 N (0, 2) (V R 12)

12
As usual, one can test the null by constructing the standardized test statistic,
 
2N V R(2) 1 D
d
N (0, 1) (V R 13).
2
If the test statistic lies outside the interval [1.96, +1.96] we reject the null at the 5% level of
significance.
2 )2 as estimate for 2 4 ,
Variance ratio is often preferred to the variance difference. If we use 2(
then the standard significance test of V D = 0 for the difference of variances will yield the same
inference as the corresponding test of (V R 1) = 0 for the ratio, since
 
2N V D(2)
d 2

2N ( 2
a ) 2N V
d R(2) 1
= b = N (0, 1) (V R 14)
24 2a2 2
But one has to admit that the variance ratio statistic is more popular amongst the researchers.
-
The above statistics can be easily generalized to any multiperiod returns. Let our sample consist
of N q + 1 observations (p0 , p1 , . . . , pN q ) where q is any integer greater than one. Define the following
estimators:
Nq
1 X 1

= (pk pk1 ) = (pN q p0 ) (V R 15)
N q k=1 Nq
Nq
1 X
a2 =
)2
(pk pk1 (V R 16)
N q k=1
N
1 X
b2 (q)
= )2
(pqk pqkq q (V R 17)
N q k=1
2 (q)

Vd b2 (q)
D(q) = a2 , V
d R(q) = b 2 (V R 18)

a

The asymptotic distributions of the variance ratio and variance difference estimators are given as
follows:
p D
D(q)
N q Vd N (0, 2(q 1) 4 ) (V R 19)
 
p D
Nq VdR(q) 1 N (0, 2(q 1)) (V R 20)

Two important refinements have been suggested.

1. The above method suggests using only non-overlapping data intervals to calculate the esti-
mates of interest. For example, to calculate (V R 7) above note that we used observations
p0 , p2 , p4 . . . , p2N to calculate the two period return suggesting a non-overlapping interval. The

13
 same holds true for any q period return. But this is clearly an inefficient way, since we are not
using all available observations. So LM suggest an alternative estimator based on overlapping
data intervals to calculate any q period return.
Nq
1 X
c2 (q)
= )2
(pk pkq q (V R 21)
N q 2 k=q

One can immediately see that this is a more efficient estimator because this uses (N q + 1 q)
b2 (q) in (V R 17) had only N observations. Thus using overlapping
observations whereas,
qperiod terms yields a more efficient estimator and hence a more powerful test.With this, we
can define the following two statistics also.

Vg c2 (q)
D(q) = a2 (V R 22)
2 (q)

V
g R(q) = c 2 (V R 23)

a

a2 and
2. The second refinement involves correcting the bias in the variance estimators c2 (q)
before dividing one by the other. Let the unbiased estimators be:
Nq
1 X
2a = )2
(pk pk1 (V R 24)
N q 1 k=1
Nq
1 X
2c (q) = )2
(pk pkq q
M k=q
 
q
M = q(N q + 1 q) 1 (V R 25)
Nq

With these, define the following statistics:

2c (q)
V D(q) = 2c (q) 2a ; V R(q) = (V R 26)
2a
Under the null, we can state then the following asymptotic distributions:

 
p D p D 2(2q 1)(q 1) 4
D(q)
N q Vg N q V D(q) N (0, (V R 27)
3q
 
p D p D 2(2q 1)(q 1)
N q (V
g R(q) 1) N q (V R(q) 1) N 0, (V R 28)
3q
These statistics can be standardized the usual way to yield asymptotically standard normal test
statistics. Using the same argument leading to (V R 14), if 4 is estimated as 4a in standardizing
the variance difference statistic (V R 27), the result is the same as the standardized variance ratio
statistic (V R 28).

14
 Sampling distribution of V R(q) under RW3: Heteroscedastic increments
Since there is near unanimity among researchers that volatility changes over time, a rejection
of random walk because of heteroscedasticity will not be of much interest. So a robust version of
the above tests is needed. LM note that the asymptotic variances of the variance ratios will clearly
depend on the type and the degree of heteroscedasticity present. So they adopt the methodology
of adjusting the variance ratio following Whites technique to account for any unknown form of
heteroscedasticity. This allows for many general form of heteroscedasticity, including ARCH type
of variance changes and changes due to deterministic factors, like seasonal factors. Under the null
of random walk with heteroscedastic increments, LM however specify the asymptotic distribution of
the variance ratio (V R(q) 1) only.
Let the asymptotic variance of V R(q) be (q). It is calculated as the weighted sum of j , where
j is the asymptotic variance of each of the j s in (V R 3). Then under the present null, (q) may
be calculated as the weighted sum of the j s where the weights are simply in relation to those in
(V R 3). More formally:

1. A heteroscedasticity consistent estimator of j is given by:

PN q
k=j+1 (pk )2 (pkj pkj1
pk1 )2
j = hP i2 (V R 29)
Nq 2
(p
k=1 k p k1
)

2. The following is the heteroscedasticity consistent estimator of (q) :

q1  2
=
X 2(q j)
(q) j (V R 30).
j=1
q

Despite the presence of heteroscedasticity, the standardized test statistic (q) follows standard normal
distribution. That is,

N q (V R(q) 1) D
(q) = p N (0, 1) (V R 31).

One can use (q) to test the null the usual way.
In practice, selecting q would be arbitrary. Comparisons of statistics against the standard normal
provide satisfactory results when N q/q is not too small. LM suggest q should not be more than one
half of the sample. Problems are only likely to arise when returns are recorded at monthly or lower
frequencies. LM opine that weekly returns are ideal to work with, as daily returns data are affected
by too much noise and sensitive to market micro structure.

15
 LM use (V R 31) to test empirically for random walks in weekly stock returns. The random
walk model is strongly rejected for the entire sample period and for all subperiods for a variety of
aggregate returns indexes and size-sorted portfolios.

Multiple variance ratio tests:

While many such tests for measuring variance ratio were suggested in the literature, all such tests
were considered as individual tests. That is, variance ratio for each q was calculated and checked
against the null of random walk separately. The question whether a time series is mean reverting or
not requires that the null holds true for all values of q. In view of this, it is necessary to conduct
joint test where a multiple comparison of variance ratios over a set of different time horizons is made.
Moreover, conducting separate individual tests for a number of q values may be misleading as it
leads to over rejection of the null hypothesis of a joint test, above the nominal size. The weakness
of tests, like LM test, is that they overlook the possibility of a joint hypothesis testing of the null of
random walk. Many tests for a joint testing of variance ratios have been suggested in the literature
but we will discuss only one such test, viz. the Chow-Denning (CD, here after) test. These multiple
variance ratio tests consider the joint null hypothesis H0 : V R(qi ) = 1 for all i = 1, 2, . . . , m, against
the alternative H1 : V R(qi ) 6= 1 for some i. A F test may sound appropriate here in testing multiple
variance ratios. But in the variance ratio context, if H0 is rejected, then further information if the
individual variance ratios or all ratios are different from one is desirable. CD suggest a test that may
be useful from this context, as shown below.

Chow-Denning multiple variance ratio test

Chow-Denning extend the Lo-MacKinlay variance ratio methodology and propose a simple testing
procedure in their paper (A simple multiple variance ratio test, J.Econometrics,Vol.58,1993,385-401)
for the multiple comparison of the set of variance ratio estimates with unity, which allows us to
examine a vector of individual test statistics while controlling for overall test size. For a set of m test
statistics, the random walk hypothesis is rejected if even if any one the estimated variance ratios is
significantly different from one.
To test the null hypothesis, CD consider the standardized variance ratio statistic implied by
(V R 28) for iid increments and by the standardized statistic in (V R 31) for heteroscedastic incre-

16
ments:

N q (V R(q) 1) [2(2q 1)(q 1)/3q]1/2

p
(q) =
1/2
p
(q) = N q (V R(q) 1)[]

CD consider a set variance ratio statistics, {(V R(qi ) 1), i = 1, 2, . . . , m}. Under the random walk
hypothesis, CD test a set of hypothesis implied by the variance ratios by considering the largest
absolute statistic:

Z1 (q) = max |(qi )|

1im

Z2 (q) = max | (qi )|

1im

CD propose the following to test Z1 (q) and Z2 (q).

Assuming that s are independent, CD propose that Z1 (q) and Z2 (q) can still be tested
against the standard normal distribution but after adjusting the size of the test also called
the significance level , to guard against an inappropriately large probability of Type I error
that arises in multiple testing. (Briefly stating, when we conduct two independent tests of a
null hypothesis at 5% level, then the probability that neither will be significant is given by
0.95 0.95 = 0.90 That is, the significance level is now actually 10% rather than the original
5% level. In general, if we conduct independent tests at the significance level, the overall
significance level will now be 1 (1 ) . Thus if = 7, then will be nearly 0.30!! leading to
the Type I error. To keep the significance level at the level, we make use of / as the correct
test size at the separate test level. This is generally referred to as the Bonferroni correction)
But CD suggest to use a sharper Bonferroni correction, = 1 (1 )1/m as the test size.

If s are correlated then CD suggest to check the test statistics, Z1 (q) and Z2 (q) against what
is called the studentized maximum modulus (SM M ) distribution. That is, SM M (, m, T ),
where is the test size, m is the number of q values and T is the sample size. Asymptotically,
however, when T = , SMM converges to standard normal with test size, . So CD define
the following two confidence intervals for the test statistics:

Z1 (q) SM M (, m, )

Z2 (q) SM M (, m, )

One has to simply compare the test statistics against the standard normal with the test size
set equal to defined above. CD also suggest a joint confidence interval for a set of variance

17
 ratio estimates:

T (V R(qi ) 1) [2(2q 1)(q 1)/3q]1/2 SM M (, m, )

1/2 SM M (, m, )
T (V R(qi ) 1) [] for i = 1, 2, . . . , m.

And, provided the sample size is large enough, one can substitute SMM critical values with
that of the standard normal distribution, with the test size given by defined above to set
the joint confidence intervals. What this procedure suggests is that one can control for the
test size of a multiple variance ratio test by simply comparing the individual variance ratios
obtained using LM procedure, against the SMM critical values. However, with finite samples,
it is still preferable to use the SMM critical values.

However the approach by CD is valid only if the vector of individual of variance ratios is
multivariate normal. This implies, that there should be little overlap while calculating the
various ratios; that is, q/T is small.

As mentioned before many multiple variance ratio tests have been recommended in the litera-
ture. A useful survey of some of these test procedures is available in the survey paper, by Amelie
Charles and Olivier Darne (Variance-ratio tests of random walk: An overview, J. Economic Surveys,,
Vol.23,2009,503-527).
-
Long-Horizon returns
Recent controversies over return-predictability over long horizons have rekindled interest on the
efficiency market hypothesis. That is to ask the question, if returns are predictable over a horizon
longer than a day or a week. To answer this question, random walk hypotheses have also been tested
sometimes with returns over a horizon as long as a month up to 5 and 10 years, over a long sample
of say 65 years. A motivation to do this is the importance of permanent and temporary components
in asset prices. In this model log prices are composed of two components: a random walk component
and a stationary process:

pt = t + yt

t = + t1 + et

yt = any zero-mean stationary process.

Here t and yt are mutually independent. In the above interpretation, t is the fundamental compo-
nent that reflects the efficient market price and yt is the temporary component that reflects a short

18
term or transitory deviation form the efficient market price, t . Such deviations could be due to
market imperfections.

How will the variance ratio behave in this set up? though for a small q V R(q) may behave in
many ways, for a large q it behaves more consistently and the ratio between permanent and transitory
components. Since yt is stationary and reverts to the process mean in the long run, a variance ratio
between transitory and permanent components must yield a variance ratio less than one. as shown
below.
Note that

rt = pt pt1 = + et + yt yt1
q1 q1
X X
rt (q) = rtj = q + etk + yt ytq
j=0 k=0
2
var [rt (q)] = q + 20 2q

where q = cov[yt ytq ] is the autocovariance function of yt . In this case the population variance
ratio becomes

var[rt (q)] q 2 + 20 2q
VR(q) = =
qvar[rt ] q( 2 + 20 21 )
2
as q
2 + 20 21
20 21
= 1 2
+ 20 21
var[yt ]
= 1
var[yt ] + var[]
var[yt ]
VR(q) 1
var[p]

where we have used the additional assumption that q 0 as q . So for a sufficiently long
horizon q, this ratio will be less than one.

Long horizon returns permanent and temporary components

Fama and French (FF) (JPE,96,1988,246-273) provided evidence against predictability of returns
using the same unobserved components framework. FF point out that zero autocorrelations amongst
returns are common in studies that test market efficiency using daily or weekly returns on a large

19
sample. But based on Summers (JF, 41,1986,591-601) observation that short horizon autocorrela-
tions ignore the possibility slowly decaying stationary components, FF use the idea of long horizon
regressions to show that returns may be predictable at least in the long horizon. That is, for re-
turn horizons longer than one year, FF report large negative autocorrelations, consistent with the
hypothesis of the presence of mean-reverting components and adding to the evidence of returns
predictability.
What are the reasons for the predictability of such long horizon returns? FF point out two
scenarios for long-horizon predictability: (1) the presence of the slow decaying price components in
an irrational market, in which prices take long but temporary swings away from the fundamental
values; (2) investor tastes for current and risky future consumption and the stochastic evolution of
the investment opportunities of firms result in time varying equilibrium expected returns that are
highly autocorrelated but mean reverting. There are other studies that attribute such mean reversals
to the tendency of stock market prices to overreact (JF,1985,40,793-805). To show the existence of a
negative autocorrelation in the long run, FF sets out the following model, based on the unobserved
components framework. (Negative autocorrelation occurs when a particular value is above average,
the next value is more likely to be below average.)

A model of stock prices

Let as before pt be log(Pt ) and we shall model pt as the sum of a random walk, qt , and a stationary
component, zt ,

pt = qt + zt

qt = + qt1 + t

where is expected drift and t is white noise. Following Summers one can assume that the
stationary component follows a slowly decaying AR(1) process,

zt = zt1 + et

where et is white noise and is close to but less than 1.0. This set up implies that only part of
the shock is permanent and the rest dissipates gradually, hinting that returns are predictable.

Implications of a stationary component

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 Since pt is the log of stock prices, the continuously compounded return from period t to t + T is

rt,t+T = pt+T pt

= [qt+T qt ] + [zt+T zt ]

The random walk price component produces white noise terms in returns. We can show that the
mean reversion of the stationary price component, zt causes negative serial correlation. The first
order autocorrelation between zt+T zt and zt ztT can be written as,
cov [zt+T zt , zt ztT ]
T =
var [zt+T zt ]
The numerator can be written as

cov [zt+T zt , zt ztT ] = z2 + 2cov [zt zt+T ] cov [zt zt+2T ]

The stationarity of zt implies that the covariances tend to 0.0 as T tends to increases, so the
covariance approaches z2 . The variance can be written as:

var [zt+T zt ] = 2z2 2cov [zt+T zt ]

and this approaches 2z2 . Thus the autocorrelation approaches or the slope of a regression of
zt+T zt on zt ztT approaches 0.5 for large T.
The slope has another interesting interpretation. Given that zt follows an AR(1), process, the
expected change from t to T is
Et [zt+T zt ] = (T 1)zt

and the covariance becomes

cov [zt+T zt , zt ztT ] = = 1 + 2T 2T z2

2
= 1 T z2

Now the following becomes clear:

The covariance is minus the variance of the T period expected change var{Et [zt+T zt ]}.

When zt follows an AR(1) model, the first order autocorrelation or the slope in the regression
of zt+T zt on zt ztT is minus the ratio of the variance of the expected change in zt to the
variance of the actual change.

21
 From the expression for expected change from period t to T shows that when is close to one,
the expected change in an AR(1) slowly approaches zt as T increases.

Likewise, the slope T is close to 0.0 for short term horizons and slowly approaches 0.5.
This illustrates the point that by concentrating on the short horizons, we may miss out this
possibility in market efficiency tests.

-
The properties of returns
Since we do not observe zt we infer its existence and properties from the behaviour of returns
itself. Let T be the slope of a regression of the return rt,t+T on rtT,t . If changes in the random walk
and stationary component of stock prices are uncorrelated, then we have

cov [rt,t+T , rtT,t ]

T =
var [rtT,t ]
T var [zt+T zt ]
=
var [zt+T zt ] + var [qt+T qt ]
varEt [zt zt+T ]

var [rtT,t ]

The above results suggest the following:

T measures the proportion of variance of T period returns explained (or predictable) from
the mean reversion of a slowly decaying prices component.

If the price does not have a stationary component, the above contribution will be zero.

If the price does not have a random component, then T = t and the slopes approach 0.5
for a large T.

Predictions about T will be complicated if stock prices have both the components. Then in
that case, the slopes in the regression of rt,t+T on rt,tT might form a U shaped form, starting
from 0.0 at short horizons, going to towards 0.5 and finally moving back to zero, as white
noise variance begins to dominate, as T .

22