2006-01: Time-Varying Risk Premia and Stock Return Autocorrelation

Autocorrelation in stock returns is one important measure of the efficiency of securities markets pricing. Autocorrelation may be a sign of genuine pricing inefficiency: partial price adjustment (PPA), in which trades occur at prices that do not fully reflect the available information. However, autocorrelation may also arise from three other sources: bid-ask bounce (BAB), nonsynchronous trading (NT), and time-varying risk premia (TVRP). TVRP is not an indication of inefficient pricing. It can arise in a securities market equilibrium because the equilibrium returns of the available investments change over time; in particular, the presence of TVRP is entirely compatible with the absence of arbitrage in securities markets. Anderson, Eom, Hahn and Park (2006) provide methods for identifying a portion of the autcorrelation that can only be attributable to PPA and TVRP. This paper provides bounds on TVRP, as a function of the return period, the time horizon over which the autocorrelations are calculated, and the variability of risk premia. We find that the impact of TVRP is negligible in the empirical setting in Anderson, Eom, Hahn and Park (2006), but could be significant in other settings, requiring correction in estimates and hypothesis tests.