Efficient Markets

Gian Maria Tomat ()
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Gian Maria Tomat: Bank of Italy

Chapter Chapter 2 in Financial Markets Efficiency and Economic Behaviour, 2023, pp 13-24 from Palgrave Macmillan

Abstract: Abstract In the earliest descriptions of the efficient markets hypothesis asset prices were modelled as a martingale. A martingale is a stochastic process with the fundamental property, that the current price is equal to the conditional expectation of the price in any future period. As a consequence, the price in any time period is equal to a cumulative sum of an initial condition and random disturbances. Therefore, its volatility increases linearly with time. More generally, when there is no arbitrage in the security market, the stock price in the current period is equal to the expected present discounted value of the subsequent period payoff, conditional on information available to economic agents. The definition of the stochastic discount factor follows from the linearity properties of the asset pricing function. When there exists a riskless asset, the conditional expected value of the stochastic discount factor is equal to the inverse of the riskless gross return. In the equivalent risk-neutral valuation expectations are taken with respect to an equivalent martingale measure.

Date: 2023
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DOI: 10.1007/978-3-031-36836-3_2

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