Market efficiency's hidden teeth: an unambiguous test for derivative securities

Nye, Z R and Johnson, T (2005) Market efficiency's hidden teeth: an unambiguous test for derivative securities. Working Paper. London Business School IFA Working Paper.

Abstract

Over the last decade, ficial economists have grown increasingly circumspect about the practical meaning of market efficiency due to the socalled joint hypothesis problem. In law, however, the concept has taken on an increasingly prominent role, meaning that the need for an operational definition cannot wait. We examine the meaning of market efficiency in contingent claims markets, where existing legal criteria are inappropriate. We propose a practical and economically meaningful test of efficiency applicable to such markets. The test is shown to be immune both to the joint hypothesis problem and to misspecification of the derivatives pricing model. We illustrate application of the test to an important recent case involving creditlinked notes.