COWLES FOUNDATION FOR RESEARCH IN
ECONOMICS Box 208281
COWLES FOUNDATION DISCUSSION PAPER NO. 970 "Actual and Warranted Relations Between Asset Prices" Andrea E. Beltratti and Robert J. Shiller February 1991 Efficient markets models assert that the price of each asset is equal to the optimal forecast of its ex-post or fundamental value. These models do not imply, however, that the covariance between two asset prices is given by the covariance between the ex-post values they respectively forecast: these two covariances can even have opposite signs. However, it is possible to place bounds on the covariance between asset prices given the covariance matrix of ex-post values. We present such bounds for both covariances and correlations and show how such bounds can be tightened using information beyond the covariance matrix of ex-post values. The methods are used to examine whether the historical correlation between the U.S. and U.K. stock markets 1919-1989 is warranted. The bounds on the warranted covariance are very wide and include the actual correlation. Keywords: Volatility, stock market, asset pricing, efficient markets, information JEL Classification: G12, G14, G15 |
