Economics Letters 18 (1985) 381-386 381

North-Holland

TESTING THE RANDOM WALK HYPOTHESIS

P o w e r versus F r e q u e n c y of O b s e r v a t i o n *

R o b e r t J. S H I L L E R a n d Pierre P E R R O N
Yale University, New Haven, C T 06520, USA

Received 12 December 1984

Power functions of tests of the random walk hypothesis versus stationary first-order autoregressive alternatives are tabulated
for samples of fixed span but various frequencies of observation.

1. Introduction

Those who test the r a n d o m walk model for prices of speculative assets often use very m a n y
observations, as data m a y be readily available on m o n t h l y , weekly or even daily basis. It is often
casually asserted that, even though the data m a y come from a relatively short sample period, with so
m a n y observations power of tests ought to be very high.
T o evaluate such a n assertion, power functions for an i m p o r t a n t class of alternatives will be
t a b u l a t e d here where the span of the data (measured in years, say, whether observations are a n n u a l ,
m o n t h l y or daily) is held fixed a n d the n u m b e r of observations is varied by c h a n g i n g the frequency of
observation. We shall see that over a substantial range of p a r a m e t e r values it is more useful to think
of power of a t-test or normalized beta test as d e p e n d i n g on the span of the data rather t h a n the
n u m b e r of observations, a n d that the power of a r u n s tests will be destroyed b y too m a n y
observations.

2. N u l l and alternative h y p o t h e s e s

The null hypothesis a n d alternative hypothesis to be considered are given by the stochastic
differential equations:

H 0 : d p t = o o d w t, t > 0, (1)

Hl:dpt=-'r(pt-I~)dt+otdw,, -~<t<oo, ~'>0, (2)

where w t is a unit W i e n e r process. I n the finance context, the r a n d o m walk null hypothesis m e a n s that
price Pt can never be described as ' t o o high' (i.e., that it can be expected to fall in the future) or ' t o o
low' (i.e., that it can be expected to rise in the future). M a n y other, more complicated, variations o n

* This research was supported by the U.S. National Science Foundation (SES-8408565) and the Universit6 de Montr6al. The
authors are indebted to P.C.B. Phillips, Stephen A. Ross and N.E. Savin for helpful discussions.

0165-1765/85/$3.30 © 1985, Elsevier Science Publishers B.V. (North-Holland)

382 R.J. Shiller, P. Perron / Testing the random walk hypothesis

the null hypothesis exist of course in the finance literature, and it is a matter for further research to
see to what extent the results obtained here extend to these other hypotheses.
The alternative hypothesis here asserts price p, is mean-reverting. In Shiller (1981) this alternative
model was referred to as a 'fads' model; stock prices move because of repeated investor fads
(represented by the innovations o~dw,) but these fads are gradually forgotten. Forgetting takes place
with an exponential decay pattern as commonly modelled by mathematical psychologists, so that ~-
might be thought of as a parameter reflecting human memory retention. If the public information set
at time t consists of the history of p so that there is steady information flow, then this hypothesis
shows the 'martingale-like behavior' that Sims (1984) argues, from arbitrage considerations, ought to
obtain.
The alternative hypothesis H~ is equivalent for t > 0 (all observations will have t > 0) to specifying
that eq. (2) holds for t > 0 and that P0 is normally distributed with mean /~ and variance o~/2~-.
If sampled at discrete points of time at intervals of length h the processes are

H0: Ph,=Ph~, 1) + U ~,
(h)
, t = 1, 2 . . . . . (3)

H1: p m = ~ + f l h ( p h . _ l ) - - ~ ) ~'~h)
-- Uht , t=..., -2, -1,0,1,2 ..... (4)

where -h,'Ih) is normally distributed with mean zero and variance ho 2 while ~h,'~h) is normally
distributed with mean zero and variance o2(1 - e x p ( - 2 ~ h ) ) / ( 2 ~ - ) . The discrete time autoregressive
parameter flh is equal to exp(--~h). Regardless of the sampling interval h, the alternative hypothesis
is that the process Ph, is first-order autoregressive around the mean /~.

3. Test statistics

We are given 1 + S / h observations P0, Ph, P2h . . . . . PS where h is the sampling interval and S is
the span of the data.
The t-test whose power we shall investigate employs the conventional t-statistic to test whether the
slope coefficient equals one in a regression of Ph, on a constant term and Ph~,-~) with T = S / h
observations,

-- 2
= (Ph~,-1)--P-h)Ph, (Ph(,-,)--P-h) , (6)
t=l t

/2 =P0 - / ~ P - h , (7)
T

P-j = T-~ E p~,-j, j = o, h, (8)

t=l

s 2 = ( T - 2) i ]~ ( P h , - /2 -- flPh{,-,)) 2" (9)

t=l

This t-statistic is not distributed as student's t under the null hypothesis, is not asymptotically
 R.J. Shiller, P. Perron / Testing the random walk hypothesis 383

n o r m a l , a n d is i n d e e d v e r y b a d l y a p p r o x i m a t e d b y the n o r m a l [see N a n k e r v i s a n d S a v i n (1983)]. T h e

n o r m a l i z e d b e t a test statistic B as u s e d in E v a n s a n d S a v i n (1981,1984) is p r o p o r t i o n a l to t h e / 3 f r o m
(6) a b o v e ,

B = (T(T- 1)/2)°5(/~- 1). (10)

T h e r u n s test uses the n u m b e r o f r u n s r in the s e q u e n c e of T o b s e r v e d p r i c e c h a n g e s ; r is o n e p l u s

the n u m b e r o f t i m e s a p r i c e c h a n g e is f o l l o w e d b y a p r i c e c h a n g e of the o p p o s i t e sign. U n d e r the
a s s u m p t i o n t h a t the t o t a l n u m b e r n~ of p o s i t i v e p r i c e c h a n g e s a n d n 2 of n e g a t i v e p r i c e c h a n g e s
( n j + n 2 = T ) are given, a n d t h a t all a r r a n g e m e n t s of t h e s e p r i c e c h a n g e s o c c u r w i t h e q u a l p r o b a b i l -
ity, t h e n the m e a n m r a n d s t a n d a r d d e v i a t i o n o r of the n u m b e r r of r u n s are

m r = 2nln2/T+ 1, (11)

or = ~ 2 n t n 2 ( 2 n , n 2- T)/(T2(T - 1)). (12)

T h e test statistic as u s e d for e x a m p l e b y F a m a (1965) to test the r a n d o m w a l k h y p o t h e s i s for stock

p r i c e s is g i v e n b y 1

K= ( r + 0.5 - m r ) o r . (13)

It c a n be s h o w n u s i n g a t h e o r e m in M o o d (1940) t h a t the r a t i o K is ( u n d e r H 0 ) a s y m p t o t i c a l l y
( w h e r e n t / T is k e p t c o n s t a n t as T is i n c r e a s e d ) n o r m a l w i t h z e r o m e a n a n d u n i t v a r i a n c e .
U n d e r o u r h y p o t h e s e s all test statistics are similar; w e c a n t h e r e f o r e c a r r y t h e s i m u l a t i o n s u n d e r
t h e a s s u m p t i o n s t h a t / , = 0 a n d 0o2 = 1 / h a n d o 2 = 2 r / ( 1 - e x p ( - 2 z h ) ) .

4. Results

P o w e r f u n c t i o n s for a size 0.05 test w e r e t a b u l a t e d w i t h 40,000 r e p l i c a t i o n s for n u m b e r o f

o b s e r v a t i o n s T = 8 to 512 a n d w i t h 10,000 r e p l i c a t i o n s for T = 1024. 2
I n the tables p o w e r is s h o w n o n l y for a single v a l u e o f • ( ~ - = 0.2) b u t p o w e r s o f tests for
~- = 0 . 2 . 2 j c a n b e f o u n d b y r e a d i n g j r o w s d o w n f r o m the p o w e r for r = 0.2. I n e a c h table, w e c a n
r e a d h o w p o w e r d e p e n d s o n the n u m b e r o f o b s e r v a t i o n s for a fixed s p a n ( r e a d i n g across rows), h o w
p o w e r d e p e n d s o n the s p a n for a fixed n u m b e r o f o b s e r v a t i o n s ( r e a d i n g d o w n c o l u m n s ) or h o w p o w e r

1 Fama (1965) used a formula for K which allows separately for +, - and 0 price changes and which reduces to this formula
if there are no zero price changes.
2 All simulations were carried out on a CDC Cyber 915 at the Universit6 de Montr6al. The N(0, 1) random deviates u~h) in (3)
and (4) were obtained from the subroutine GGNML of the International Mathematical and Statistical Library (IMSL)
package, version 9.1. In the first step the empirical distributions under the null hypothesis of the t-statistic and of the
normalized fl-statistic were computed with 20,000 replications. The series Pht were generated from (3) for t =1, ...,T
starting from the initial condition Po = 0. The significance points were taken from the sorted arrays. Critical values were
taken as the 2.5 and 97.5 percentage points of the empirical distributions. Critical values for the runs test were taken from the
assumption that the statistic K was normally distributed. In the second step the empirical power functions of the tests using
the significance points from step one were computed with 20,000 replications (except for T = 1024 which used 10,000). Under
the alternative the series Pht were generated from (4) for t =1, ...,T starting from the initial condition P0 = U o / ( 1 -
exp(- 2 zh))°5. This procedure was repeated twice (except for T = 1024) and the tables show the averages of the two power
computations.
384 R.J. Shiller, P. Perron / Testing the random walk hypothesis

Table 1
Power of a two-tailed t-test; number of observations: T = S/h; S: span of the data. a

S 8 16 32 64 128 256 512 1024

8 0.040 0.038 0.037 0.039 0.039 0.041 0.037 0.039
16 0.042 0.042 0.043 0.044 0.045 0.045 0.044 0.043
32 0.059 0.071 0.079 0.085 0.088 0.089 0.088 0.086
64 0.111 0.191 0.246 0.284 0.296 0.304 0.307 0.307
128 0.175 0.470 0.701 0.824 0.872 0.892 0.901 0.907
256 0.195 0.681 0.973 0.999 1.000 1.000 1.000 1.000
512 0.196 0.726 0.997 1.00 1.00 1.00 1.00 1.00
1024 0.196 0.728 0.998 1.00 1.00 1.00 1.00 1.00

Lower
bound - 3.893 - 3.421 - 3.271 - 3.181 - 3.155 - 3.137 - 3.135 - 3.135

Higher
bound 0.562 0.379 0.312 0.275 0.240 0.217 0.225 0.246

a Table gives power of two-tailed t-test at 0.05 level against alternative with 7 = 0.2. Thus, for example, if l' = 0.2 where time
is measured in years [so that H 1 would predict a rate of decline for p of 0.2(p~ - / ~ ) per year] and we have 128 quarterly
observations covering a span of 32 years, the probability of rejecting is 0.088. If T = 0.05 where time is measured in years
and we have 128 quarterly observations covering a span on 32 years, then the probability of rejecting is given by 0.039. The
final rows give the critical values of the t-statistic, eq. (5).

Table 2
Power of a two-tailed test with the normalized estimator of beta; number of observations: T = S/h; S: span of the data. a

S 8 16 32 64 128 256 512 1024

8 0.050 0.047 0.044 0.045 0.045 0.046 0.046 0.046
16 0.058 0.059 0.057 0.058 0.060 0.060 0.061 0.058
32 0.094 0.116 0.123 0.126 0.128 0.130 0.133 0.132
64 0.185 0.309 0.371 0.411 0.427 0.434 0.445 0.439
128 0.283 0.644 0.843 0.925 0.953 0.964 0.969 0.971
256 0.312 0.828 0.993 1.00 1.00 1.00 1.00 1.00
512 0.313 0.860 1.00 1.00 1.00 1.00 1.00 1.00
1024 0.313 0.862 1.00 1.00 1.00 1.00 1.00 1.00

Lower
bound - 6.837 - 8.717 - 10.174 - 10.988 - 11.472 - 11.693 - 11.784 - 11.897

Higher
bound 0.775 0.486 0.384 0.350 0.297 0.276 0.283 0.315

a Table gives power of a two-tailed normalized beta test of the null hypothesis against alternative with l' = 0.2. The final rows
give the critical values for the statistic B, eq. (10).

depends on the number of observations when, as is usually assumed, span is proportional to

observations (reading along diagonals from upper left to lower right). 3
For the t-test and normalized b e t a t e s t , t a b l e s 1 a n d 2, w e s e e t h a t w i t h s h o r t s p a n s t h e r e i s n e v e r

3 Some of the numbers in the tables correspond approximately with power computations in the literature [Dickey (1976),
Dickey and Fuller (1979), Evans and Savin (1984), Fuller (1976), and Nankervis and Savin (1983)] and in these cases our
results were roughly confirmed.
 R.J. Shiller, P. Perron / Testing the random walk hypothesis 385

Table 3
Power of a two-tailed runs test; number of observations: T = S / h ; S: span of the data. a

S 8 16 32 64 128 256 512 1024

8 0.048 0.045 0.062 0.050 0.050 0.048 0.050 '0.054
16 0.056 0.044 0.065 0.050 0.049 0.049 0.050 0.055
32 0.076 0.053 0.074 0.055 0.052 0.048 0.051 0.056
64 0.110 0.080 0.105 0.068 0.061 0.052 0.053 0.055
128 0.141 0.139 0.189 0.123 0.094 0.072 0.063 0.059
256 0.150 0.200 0.358 0.280 0.214 0.141 0.104 0.082
512 0.151 0.217 0.504 0.566 0.532 0.385 0.256 0.170
1024 0.151 0.218 0.542 0.756 0.877 0.833 0.682 0.464

Lower
bound - 1.96 - 1.96 - 1.96 - 1.96 - 1.96 - 1.96 - 1.96 - 1.96

Higher
bound 1.96 1.96 1.96 1.96 1.96 1.96 1.96 1.96

a Table gives power of a two-tailed runs test at the 0.05 level against alternative with ~, = 0.2. The final rows give the critical
values for the runs test statistic K, eq. (13).

m u c h power. 4 F o r i n t e r m e d i a t e spans (32 or 64) p o w e r rises g r a d u a l l y as o b s e r v a t i o n s are increased

a n d then levels off s u b s t a n t i a l l y b e l o w one. Over a s u b s t a n t i a l range, p o w e r d e p e n d s m o r e on the
s p a n of the d a t a t h a n on the n u m b e r of observations.
F o r the t w o - t a i l e d runs test, table 3, we see that if s p a n is held fixed as the n u m b e r of o b s e r v a t i o n s
is increased, p o w e r tends to rise a n d then fall b a c k t o w a r d s the size of the test. If there are m a n y
observations, there is never m u c h power, for a n y spans shown in the table.
It is thus w r o n g to p r e s u m e that p o w e r of tests of the r a n d o m walk hypothesis must be high j u s t
b e c a u s e there are very m a n y observations. 5 In all the tables shown here, p o w e r does not a p p r o a c h
one in the limit as we either move to the right along rows or move d o w n along columns, b u t
a p p r o a c h e s one as a limit only if we move d i a g o n a l l y d o w n from u p p e r left to lower right, i.e.,
increasing b o t h s p a n a n d n u m b e r of observations. 6 Some of the relevant a s y m p t o t i c d i s t r i b u t i o n s are
d e v e l o p e d in Perron (1984).

References

Dickey, David A., 1976, Estimation and hypothesis testing in non-stationary time series, unpublished Ph.D. dissertation (Iowa
State University, Ames, IA).
Dick@, David A. and Wayne A. Fuller, 1979, Distribution of the estimates for the autoregressive time series with a unit root,
Journal of the American Statistical Association 74, no. 366, 427-431.
Dickey, David A. and Wayne A. Fuller, 1981, Likelihood ratio statistics for autoregressive time series with a unit root,
Econometrica 49, no. 4, 1957-1972.
Evans, G.B.A. and N.E. Savin, 1981, Testing for unit roots: 1, Econometrica 49, no. 3, 753-780.
Evans, G.B.A. and N.E. Savin, 1984, Testing for unit roots: 2, Econometrica 52, no. 5, 1241-1270.

4 When the span of the data is very short, the test is slightly biased (the power is less than the size of the test of 0.05). Such a
bias in the case of a fixed startup at the mean alternative was noted before by Nankervis and Savin (1983).
5 See also Summers (1982).
6 For some values of S or T in the tables the power is given as 1.000. This reflects the fact that the power is very close to one
for these values, but not that the power has the limit of one along either rows or columns.
386 R.J. Shiller, P. Perron / Testing the random walk hypothesis

Fama, Eugene, 1965, The behavior of stock market prices, Journal of Business 38, Jan., 34 105.
Fuller, Wayne A., 1976, Introduction to statistical time series (Wiley, New York).
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Nankervis, J.C. and N.E. Savin, 1983, Testing the autoregressive parameter with the t statistic, unpublished (Trinity College,
Cambridge).
Perron, Pierre, 1984, The distribution of the least squares estimator of the autoregressive coefficient with a continuum of data,
unpublished (Yale University, New Haven, CT).
Shiller, Robert J., 1981, The use of volatility measures in assessing market efficiency, The Journal of Finance 36, no. 2,
291-304.
Sims, Christopher A., 1984, Martingale-like behavior of prices and interest rates, Discussion paper no. 205 (University of
Minnesota, Minneapolis, MN) Oct.
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Cambridge, MA).