What is the joint hypothesis problem in market efficiency testing?

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AcadiFi · Accepted Answer

Any test of market efficiency is simultaneously a test of (1) market efficiency AND (2) the asset pricing model used to compute expected (or risk-adjusted) returns. You cannot reject efficiency without also assuming your pricing model is correct. If you find abnormal returns, you can't tell whether markets are inefficient OR your model is misspecified. Example: a researcher, Dr. Aniruddh Venkataraman, tests whether small-cap stocks earn abnormal returns using CAPM. He finds +3.2% annual alpha on a small-cap portfolio, t-stat 2.7. Conclusions: (a) markets are inefficient (size premium is mispricing), OR (b) CAPM misses a size risk factor (markets ARE efficient but CAPM is wrong). Fama-French added SMB/HML factors and the alpha shrank to 0.4%. But is the 3-factor model 'the' pricing model? Adding momentum (Carhart) shrinks alpha further. Each new factor raises the question: is it compensation for risk (efficient) or a behavioral mispricing (inefficient)? This is why anomalies literature is philosophically unsettled. CFA exam: know that any stated 'violation' of EMH requires specifying which pricing model is assumed.

What is the joint hypothesis problem in market efficiency testing?

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