This document is meant to show the Random Walk Hypothesis of the Stock

Market.

Pt+1 = aPt + t+1

Taking expectations:

Et Pt+1 = aEt Pt + Et t+1

If we assume:

t ∼ N (0, σ 2 ), cov(t , s ) = 0 ∀t, s, t 6= s

Et Pt+1 = aEt Pt ∴ Et Pt+1 = aPt

If a = 1, we have:
Et Pt+1 = Pt
Which is a Random Walk (special case of a Martingale).

Therefore: the expected future price of a stock one period from now is equal
to the present price. Iterating on the Expectations operator:

Et+1 Pt+2 = Pt+1

Hence:
Et (Et+1 Pt+2 ) = Pt = Et Pt+2
Thus, the expected future price of a stock for every period into the future
(if it follows a Random Walk) is equal to the current price.

Intuitively: all information available is priced into the stock. Hence, the
most accurate expected future value of the stock is its current price.

To better understand the properties of a Martingale process, you can visit

this website

Random Walk time series are said to be unit root processes. The reason
why is because the characteristic polynomial has one of its roots exactly equal
to 1. Let's assume the time series of a stock can be characterized by a Random
Walk with drift:
Pt+1 = a + Pt + t+1
We have that this is a rst order dierence equation in P. We know that to
nd a solution to this equation, we need to solve for the root of the characteristic
polynomial. Dening the lag operator as:

Pt = LPt+1

We have that:

Pt+1 − LPt+1 = 0 ∴ Pt+1 (1 − L) = 0

1
 Thus, this polynomial has a unit root solution. Unit root processes have
several interesting properties. In particular, they are not stationary processes.
Why? Beacuse the variance increases over time. To show it, replacing itera-
tively:
Pt = a + Pt−1 + t

Pt+1 = a + a + Pt−1 + t+1 + t = 2a + Pt−1 + t+1 + t

And remembering:

Pt−1 = a + Pt−2 + t−1 =⇒ Pt+1 = 3a + Pt−2 + t−1 + t + t+1

If we continue iterating until t=0 and assume WLOG that P0 = a +  0 :

t+1
X
Pt+1 = (t + 1)a + s
s=0

Computing the variance of the process (and remembering that cov(t , s ) =

0 ∀t, s, t 6= s):
t+1
X
var(Pt+1 ) = var(s ) = (t + 1) ∗ σ 2
s=0

Thus, variance increases over time! That's why this is not a stationary
process, and no predictions can be made for this series. In the case of a random
walk with drift, not even the mean is stationary.