Estimation Risk, Market Efficiency, and the Predictability of Returns

Jonathan Lewellen and Jay Shanken ()

No 7699, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: In asset pricing, estimation risk refers to investor uncertainty about the parameters of the return or cashflow process. We show that with estimation risk the observable properties of prices and returns can differ significantly from the properties perceived by rational investors. In particular, parameter uncertainty will tend to induce return predictability in ways that resemble irrational mispricing, and prices can violate familiar volatility bounds when investors are rational. Cross-sectionally, expected returns deviate from the CAPM even if investors attempt to hold mean-variance efficient portfolios, and these deviations can be predictable based on past dividends and prices. In short, estimation risk can be important for characterizing and testing market efficiency.

JEL-codes: C11 D83 (search for similar items in EconPapers)
Date: 2000-05
New Economics Papers: this item is included in nep-fin and nep-fmk
Note: AP
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Citations: View citations in EconPapers (5)

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