Methodological issues in asset pricing: Random walk or chaotic dynamics

We analyze the theoretical foundations of the efficient market hypothesis b y stressing the efficient use of information and its effect upon price vola tility. The "random walk" hypothesis assumes that price volatility is exoge nous and unexplained. Randomness means that a knowledge of the past cannot help to predict the future. We accept the view that randomness appears beca use information is incomplete. The larger the subset of information availab le and known, the less emphasis one must place upon the generic term random ness. We construct a general and well accepted intertemporal price determin ation model, and show that price volatility reflects the output of a higher order dynamic system with an underlying stochastic foundation. Our analysi s is used to explain the learning process and the efficient use of informat ion in our archetype model. We estimate a general unrestricted system for f inancial and agricultural markets to see which specifications we can reject . What emerges is that a system very close to our archetype model is consis tent with the evidence. We obtain an equation for price volatility which lo oks a lot like the GARCH equation. The price variability is a serially corr elated variable which is affected by the Bayesian error, and the Bayesian e rror is a serially correlated variable which is affected by the noisiness o f the system. In this manner we have explained some of the determinants of what has been called the "randomness" of price changes. (C) 1999 Elsevier S cience :B.V. All rights reserved. JEL classification: D82; D83; D84; G12; G 14.