15.

481x – FINANCIAL MARKET

DYNAMICS AND HUMAN
BEHAVIOR

Introduction to
Random Walks
DRUNK MAN WALKING!

General Recipe:
• You are on a 1-dimensional line.
• Start at some point X0 = 0
• At time t, your position is Xt-1: generate a random number 𝜖t
• Take a step of size 𝜖t
• Your position at time t: Xt = Xt-1 + 𝜖t

Example: Using coin flips!

• At each second, flip a coin
• If get H, take 1 step forward (𝝐 = +1); If get T, take 1 step back (𝝐 = -1)

𝜖t

Xt-1 Xt
DRUNK MAN WALKING!

General Recipe:
• You are on a 1-dimensional line.
• Start at some point X0 = 0
• At time t, your position is Xt-1: generate a random number 𝜖t
• Take a step of size 𝜖t
• Your position at time t: Xt = Xt-1 + 𝜖t

Example: Using coin flips!

• At each second, flip a coin
• If get H, take 1 step forward (𝝐 = +1); If get T, take 1 step back (𝝐 = -1)

-3 -2 -1 0 1 2 3
ARITHMETIC RANDOM WALK

Consider a walk with Normal-sized steps: (with a constant drift μ)

𝑋! = 𝜇 + 𝑋!"# + 𝜖! , where 𝜖! ∼ 𝑁(0, 𝜎$% ) are independently generated

i.e., we have 𝐸[𝜖! ] = 0 and 𝐸[𝜖! 𝜖!&' ] = 0.

Note: 𝑋! ∼ 𝑁(𝑠𝑜𝑚𝑒 𝑚𝑒𝑎𝑛, 𝑠𝑜𝑚𝑒 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒)

ARITHMETIC RANDOM WALK - MEAN

Consider a walk with Normal-sized steps: (with a constant drift μ)

𝑋! = 𝜇 + 𝑋!"# + 𝜖! , where 𝜖! ∼ 𝑁(0, 𝜎$% ) are independently generated

i.e., we have 𝐸[𝜖! ] = 0 and 𝐸[𝜖! 𝜖!&' ] = 0. Recall: (by linearity!)

𝐸 𝜇 + 𝑋!"# + 𝜖! = 𝜇 + 𝐸[𝑋!"#] + 𝐸[𝜖! ]

Note: 𝑋! ∼ 𝑁(𝑠𝑜𝑚𝑒 𝑚𝑒𝑎𝑛, 𝑠𝑜𝑚𝑒 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒)

So: E 𝑋! = 𝜇 + 𝐸 𝑋!"# + 𝐸 𝜖!
= 𝜇 + 𝐸 𝑋!"#
= 𝜇 + 𝜇 + 𝐸 𝑋!"%
= 2𝜇 + 𝐸 𝑋!"%
=⋯
= 𝑡 × 𝜇 + 𝑋(

Theorem: E[Xt] = μt + X0
ARITHMETIC RANDOM WALK - VARIANCE

Consider a walk with Normal-sized steps: (with a constant drift μ)

𝑋! = 𝜇 + 𝑋!"# + 𝜖! , where 𝜖! ∼ 𝑁(0, 𝜎$% ) are independently generated

i.e., we have 𝐸[𝜖! ] = 0 and 𝐸[𝜖! 𝜖!&' ] = 0.

Recall: (by independence!)
𝑉𝑎𝑟 𝑋!"# + 𝜖! = 𝑉𝑎𝑟 𝑋!"# + 𝑉𝑎𝑟 𝜖!
Note: 𝑋! ∼ 𝑁(𝜇𝑡, 𝑠𝑜𝑚𝑒 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒)
So: 𝑉𝑎𝑟(𝑋! ) = 𝑉𝑎𝑟(𝑋!"# ) + 𝑉𝑎𝑟(𝜖! )
= 𝜎$% + 𝑉𝑎𝑟(𝑋!"# )
= 𝜎$% + 𝑉𝑎𝑟 𝑋!"% + 𝜎$%
= 2𝜎$% + 𝑉𝑎𝑟 𝑋!"%
=⋯
= 𝑡 ×𝜎$%

Theorem: Var(Xt) = 𝝈𝜖2 t

ARITHMETIC RANDOM WALK

In class we will derive it in a very similar way:

PROPERTIES OF THE RANDOM WALK

Consider a walk with Normal-sized steps: (with a constant drift μ)

𝑋! = 𝜇 + 𝑋!"# + 𝜖! , where 𝜖! ∼ 𝑁(0, 𝜎$% ) are independently generated

i.e., we have 𝐸[𝜖! ] = 0 and 𝐸[𝜖! 𝜖!&' ] = 0.

1) Normality of Increments:
Increments 𝑋! − 𝑋!"# = 𝜇 + 𝜖! follow a 𝑁(𝜇, 𝜎$% ) distribution.

2) Independence and Normality of Increments:

Non-overlapping increments (𝑋! − 𝑋!"' ) and (𝑋!&) − 𝑋!&)"'* ) are independent
𝑋! − 𝑋!"# = 𝜇 + 𝜖!
For example: B
𝑋!&) − 𝑋!&)"# = 𝜇 + 𝜖!&)

and the 𝜖’s are independent by assumption.

FOR PRICES… GEOMETRIC RANDOM WALKS!

Prices do not follow an arithmetic random walk…

… why? Well, negative prices don’t make much sense!

Solution: Log(Pricet) follows an arithmetic random walk!

Log(𝑃! ) = 𝜇 + Log(𝑃!"# ) + 𝜖! , where 𝜖! ∼ 𝑁(0, 𝜎$% ) are independent

In that case we say that Pt follows a Geometric Random Walk!

So: 𝑃! = 𝑃!"# × 𝑒 +&$! ≥ 0 as desired

We define log-returns as:

𝑃!
𝑅! = Log 𝑃! − Log 𝑃!"# = Log = 𝜇 + 𝜖! ⟹ 𝑅! ∼ 𝑁 𝜇, 𝜎$%
𝑃!"#
è In this model, stock returns are independent and normally distributed!
15.481x – FINANCIAL MARKET
DYNAMICS AND HUMAN
BEHAVIOR

Variance Ratio Tests

of the Random Walk
RECALL:
VARIANCE RATIO TEST

Recall that, under the random-walk hypothesis, Log-Returns should follow:

𝑃!
𝑅! = Log = 𝜇 + 𝜖!
𝑃!"#
Hence, at two different times s and t:
𝑉𝑎𝑟(𝑅! + 𝑅) ) = 𝑉𝑎𝑟 𝑅! + 𝑉𝑎𝑟 𝑅) + 2 𝐶𝑜𝑣 𝑅! , 𝑅)
= 𝑉𝑎𝑟 𝜖! + 𝑉𝑎𝑟 𝜖) + 2 𝐶𝑜𝑣 𝜇 + 𝜖! , 𝜇 + 𝜖)
= 𝜎$% + 𝜎$% + 2 𝐶𝑜𝑣 𝜖! , 𝜖)
= 2 𝜎$% + 0
Hence:

KLM(N! ON" )
Theorem: Under the RW Hypothesis,
PQ#$
= 1
VARIANCE RATIO TEST

Recall that, under the random-walk hypothesis, Log-Returns should follow:

𝑃!
𝑅! = Log = 𝜇 + 𝜖!
𝑃!"#

If the RW hypothesis does not hold:

𝑉𝑎𝑟(𝑅! + 𝑅) ) = 𝑉𝑎𝑟 𝑅! + 𝑉𝑎𝑟 𝑅) + 2 𝐶𝑜𝑣 𝑅! , 𝑅)
= 2 𝜎$% + 2 𝐶𝑜𝑣 𝑅! , 𝑅)
Hence,

𝑉𝑎𝑟(𝑅! + 𝑅) ) 𝐶𝑜𝑣 𝑅! , 𝑅)
% = 1 + % = 1 + 𝐶𝑜𝑟𝑟 𝑅! , 𝑅) = 1 + 𝜌!, )
2𝜎$ 𝜎$

KLM(N! ON" )
Theorem: In general,
PQ#$
= 1 + 𝜌T, U
VARIANCE RATIO TEST

Recall:

KLM(N! ON" )
Theorem: Under the RW Hypothesis,
PQ#$
= 1

KLM(N! ON" )
Theorem: In general,
PQ#$
= 1 + 𝜌T, U

So, to test the random-walk hypothesis:

"#$(&$ '&% )
1) Calculate:
)*&'
2) If this ratio is close to 1, the RW Hypothesis holds!
3) If this ratio is far from 1, the RW Hypothesis is incorrect!

… so what does the data say?

REJECTING THE RANDOM WALK

Source: Lo and MacKinlay (1988)

WHAT ARE T-STATISTICS AND P-VALUES?

• t-Statictics:
• Suppose you want to test the hypothesis 𝐻( : 𝛽 = 𝛽( , about some parameter 𝛽
• For example, think of 𝛽 as being the slope in a regression y = 𝛼 + 𝛽 𝑥 + 𝜖
• In this case, you usually want to test 𝐻( : 𝛽 = 0 (i.e., is my slope “significant”)
+ with standard error SE[𝛽]
• You use an estimator 𝛽, /

V XW%
W
• The t-stat is: 𝑡 = V ∼ 𝑇[X\ under H0
YZ[W]
• n = # of observations
• k = # of regressors (including 𝛼)
• Note: assumes normally distributed and
homoscedastic error terms 𝜖

• p-Values: 𝑝: = Pr 𝑇-"' > |t|

• We often require 𝑝 < 5% to claim “statistical significance”
REJECTING THE RANDOM WALK

Source: Lo and MacKinlay (1988)

REJECTING THE RANDOM WALK

An Empirical Puzzle
• Random walk strongly rejected for stock indexes
• Random walk not rejected for individual stocks
• Rejections stronger for smaller-cap stocks
• Rejections stronger for daily and weekly returns
• Rejections are due to positive autocorrelation
• Rejections cannot be explained away by:
• Nonsynchronous trading, heteroskedasticity, January effect,
size effect