Market efficiency's hidden teeth: an unambiguous test for derivative securities

Finance

IFA Working Paper

2005

Over the last decade, financial economists have grown increasingly circumspect about the practical meaning of market efficiency due to the so-called joint hypothesis problem. In law, however, the concept has taken on an increasingly prominent role, meaning that the need for an operational definition cannot wait. We examine the meaning of market efficiency in contingent claims markets, where existing legal criteria are inappropriate. We propose a practical and economically meaningful test of efficiency applicable to such markets. The test is shown to be immune both to the joint hypothesis problem and to misspecification of the derivatives pricing model. We illustrate application of the test to an important recent case involving credit-linked notes.

Institute of Finance and Accounting

FIN 437

IFA Working Paper

No