Martingales, Detrending Data, and the Efficient Market Hypothesis.pdf

Martingales, Detrending Data, and the Efficient Market Hypothesis Joseph L. McCauley+, Kevin E. Bassler++, and Gemunu H. Gunaratne+++ Physics Department University of Houston Houston, Tx. 77204-5005 jmccauley@ +Senior Fellow COBERA Department of Economics J.E.Cairnes Graduate School of Business and Public Policy NUI Galway, Ireland ++Texas Center for Superconductivity University of Houston Houston, Texas 77204-5005 +++Institute of Fundamental Studies Kandy, Sri Lanka Key Words: Martingales, Markov processes, detrending, memory, stationary and nonstationary increments, correlations, efficient market hypothesis. Abstract We discuss martingales, detrending data, and the efficient market hypothesis for stochastic processes x(t) with arbitrary diffusion coefficients D(x,t). Beginning with x-independent drift coefficients R(t) we show that Martingale stochastic processes generate uncorrelated, generally nonstationary increments. Generally, a test for a martingale is therefore a test for uncorrelated increments. A detrended process with an x-dependent drift coefficient is generally not a martingale, and so we extend our analysis to include the class of (x,t)-dependent drift coefficients of interest in finance. We explain why martingales look Markovian at the level of both simple averages and 2-point correlations. And while a Markovian market has no memory to exploit and presumably cannot be beaten systematically, it has never been shown that martingale memory cannot be exploited in 3-point or higher correlations to beat the market. We generalize our Markov scaling solutions presented earlier, and also generalize the martingale formulation of the efficient market hypothesis (EMH) to include (x,t)- dependent drift in log returns. We also use the analysis of this paper to correct a misstatement of the ‘fair game’ condition in terms of serial correlations in Fama’s paper on the EMH. We end with a discussion of Le