Are Co-integrated Stock Prices Consistent with the Efficient Market Hypothesis?
This paper responds to the unsatisfactory argument that there is nocorrespondence between co-integration and the efficient markethypothesis. A law of one co-integrating vector of prices is proposed forthe exchange rate and domestic and overseas stock prices. Markets musttherefore be efficient in long-run equilibrium because no arbitrageopportunities exist. However, arbitrage activity via the disequilibriumerror correction allows above-average (risk-adjusted) returns to beearned in the short run. The elimination of these arbitrage opportunitiesmeans that stock market inefficiency in the short run ensures stock marketefficiency in the long run.