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Financial Economics, Return Predictability and Market Efficiency

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Notes

  1. 1.

    The linearization parameter ρ is tied to the average dividend–price ratio, and is held fixed at 0.9635.

Abbreviations

Stock return:

The stock return in this entry refers to the return on the portfolio of all stocks that are traded on the three largest equity markets in the US: the NYSE, NASDAQ, and AMEX. The return is measured as the price of the stock at the end of the year plus the dividends received during the year divided by the price at the beginning of the year. The return of each stock is weighted by its market capitalization when forming the portfolio. The source for the data is CRSP.

Dividend‐price ratio and dividend yield:

The dividend‐price ratio of a stock is the ratio of the dividends received during the year divided by the price of the stock at the end of the year. The dividend yield, instead, is the ratio of the dividends received during the year divided by the price of the stock at the beginning of the year. The stock return is the sum of the dividend yield and the capital gain yield, which measures the ratio of the end-of-year stock price to the beginning-of-year stock price.

Predictability:

A stock return \( { r_{t+1} } \) is said to be predictable by some variable x t if the expected return conditional on x t , \( { E[r_{t+1}\mid x_t] } \), is different from the unconditional expected return, \( { E[r_{t+1}] } \). No predictability means that the best predictor of tomorrow's return is the constant, unconditional average return, i. e., \( { E[r_{t+1}\mid x_t]=E[r_{t+1}] } \). When stock returns are unpredictable, stock prices are said to follow a random walk.

Market model:

The market model links the return on any asset i, \( { r_{it} } \) to the return on the market portfolio (r t ). Under joint normality of returns, it holds:

$$ r_{it}=\alpha_i + \beta_i r_{t} + \varepsilon_{it}\:, $$
(1)

with \( { E[\varepsilon_{it}]=0 } \) and \( { {\mathrm{Var}}[\varepsilon_{it}] = \sigma^2_{\varepsilon_{i}} } \), see [16]. The typical assumption in the literature until the 1980s has been that \( { E[r] } \) is constant.

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Author information

Authors and Affiliations

  1. Department of Finance, Stern School of Business, New York University, New York, USA

    Stijn van Nieuwerburgh

  2. Department of Finance, Tilburg University, Tilburg, The Netherlands

    Ralph S. J. Koijen

Authors
  1. Stijn van Nieuwerburgh
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  2. Ralph S. J. Koijen
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Editors and Affiliations

  1. RAMTECH LIMITED, 122 Escalle Lane, Larkspur, CA, 94939, USA

    Robert A. Meyers Ph. D. (Editor-in-Chief) (Editor-in-Chief)

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van Nieuwerburgh, S., Koijen, R.S.J. (2009). Financial Economics, Return Predictability and Market Efficiency. In: Meyers, R. (eds) Encyclopedia of Complexity and Systems Science. Springer, New York, NY. https://doi.org/10.1007/978-0-387-30440-3_206

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