This years Nobel Memorial Prize in Economic Sciences was awarded on Monday to Eugene F. Fama, Lars Peter Hansen and Robert J. Shiller.

Most of the popular press has focused on the obvious dichotomy of the seminal contributions of Fama and Shiller, and have concluded that Shiller was right.

Markets are Gray

This year’s prize has been more controversial than most. A substantial amount of the criticism of this year Nobel has centered around the differences in the original contributions of Fama and Shiller. As Justin Wolfers succinctly summarized this difference as:

… financial markets are efficient (Fama), except when they’re not (Shiller), …

One article form The New Yorker was particularly dismissive of efficient markets.

The black and white view adopted in the main stream press is too simplistic to understand market efficiency. It is useful to consider a substantially more gray definition of market efficiency, first advanced by another Nobel laureate, Clive. W. J. Granger in a paper with Allan Timmerman. This extended definition adds two important dimensions to to the definition of weak form efficiency.

The first is the horizon, \(h\). Actual arbitrage capital operates on frequencies ranging from microseconds to quarters, and so it is essential to consider the time scale when asking whether prices are weak form efficient.

The second extension is technology, which can be thought of as a combination of actual physical technology, for example the existence of Twitter, and the understanding of econometric and statistical techniques relevant for capturing arbitrage opportunities. Technology is constantly evolving and existing arbitrage opportunities disappear as understanding of the risk/reward trade off evolves. This has clearly occurred at the shortest horizons where high-frequency trading has evolved from simple strategies trading the same asset of different markets (e.g. IBM in New York and Toronto) to complex strategies trading hundreds of assets to eliminate arbitrage between futures, ETFs and the underlying components of an index. Similarly, recent advances allow real-time sentiment analysis constructed from Twitter feeds to be used to detect price trends.

## Understanding the Risk

In addition to both horizon and technology, it is essential to understand the risk of these price trends. There is an increasing list of examples where strategies that consistently generated profits for years experienced sharp reversals. In some examples, these reversals are so sharp that a decade or more or accumulated profit is eliminated in a couple of months. This was the case for simple momentum strategies in 2002 and for statistical arbitrage strategies.in August 2007. This type of extremely skewed risk-return relationship substantially complicates the econometric analysis of market efficiency.

The Grossman-Stiglitz paradox states that the absence of arbitrage requires arbitrage. The contradiction, combined with a more nuanced view of efficient markets leads to the relevant question :

*Under what conditions are markets efficient?*