Behavior of Asset Prices

LITTLE IS KNOWN ABOUT THE DETERMINANTS OF THEBEHAVIOR OF ASSET PRICES, BUT THERE IS CLEAR

EVIDENCE THAT THEY DO NOT BEHAVE RATIONALLY:A DISCUSSION OF THE ISSUE

A procedure which permits an accurate and timely prediction of common stock and bond prices has been sought since the inception of capital markets. The quest, thus far, has proved to be a largely futile effort. As the rewards to be derived from such a procedure are great, however, the quest has endured over the decades.

The Character of Stock Price Changes

Bachelier (1900) provided important early work on the problem of predicting stock price changes, reasoning that the expected value of a stock price at time t + 1, knowing the time series of all past prices, is simply the present price. The eventualresult of this work was the Random Walk Model.

Bachelier (1900) theorized that successive price changes are drawn from the same probability distribution. Based on a "fair game" characterization of the marketplace, it was assumed that price changes followed a random walk with a normal distribution. Therefore, assuming independent price changes on successive transactions, and with a process having finite variance, application of the Central Limit Theorem led to a conclusion that, after many transactions, the limiting distribution must be normal. At the time Bachelier wrote, very little empirical evidence could be marshaled to support these claims. Thus, the work lay dormant for 50 years, until analysis o

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Category: Economics - B