ECONOMETRICS: Multi-Horizon Test for Market Efficiency; Dr Merrick Li (Chinese University of Hong Kong)

Abstract: 

In efficient markets, asset returns show no predictability over short periods, such as daily or intraday intervals, where expected returns are nearly zero. However , the presence of pricing errors---transitory components of asset prices reflecting various market frictions or biases---induces return reversals. These reversals provide evidence against market efficiency, particularly in terms of liquidity provision. We propose to test market efficiency based on the joint inference of the covariances of observed returns over multiple horizons. We show that analyzing a small set of horizons is sufficient to detect inefficiencies caused by a wide range of transitory pricing errors, both theoretically and practically. Extensive simulations highlight the superiority of our multi-horizon approach over traditional tests, especially when pricing errors are weak and exhibit complex serial dependencies. Moreover, our test statistic serves as a natural liquidity measure that can effectively identify financial crisis with significant liquidity drains.

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