The Quarterly Review of Economics and Finance 42 (2002) 599–609 Fractional integration and mean reversion in stock prices  Guglielmo Maria Caporale a,∗ , Luis A. Gil-Alana b a Centre for Monetary and Financial Economics, South Bank University, 103 Borough Road, London SE1 0AA, UK b Institut für Statistik und Ökonometrie, Humboldt Universität zu Berlin, Germany Abstract The Efficient Market Hypothesis (EMH) is frequently tested by measuring the degree of mean reversion in stock prices, since highly predictable changes might indicate that investors are not fully rational. Existing studies often rely on statistical tests which impose too restrictive assumptions on the time series behavior of the series of interest, and have very low power. This paper uses a test for unit roots and other nonstationary (and stationary) hypotheses—recently developed by Robinson (1994)—which allows for fractional alternatives and outperforms rival statistics. Its application to U.S. real stock returns suggests that there is no permanent component in stock prices, since the series examined is close to being I(0). The key question then becomes whether there exists an autocorrelated structure, which would imply that the series is perfectly predictable, and hence that the market might not be efficient. © 2002 Board of Trustees of the University of Illinois. All rights reserved. JEL classification: C120, G120, G140 Keywords: Efficient markets hypothesis (EMH); Mean reversion; Fractional integration 1. Introduction According to the efficient market hypothesis (EMH) it should not be possible, using pub- licly available information, to make systematic profits over and above transaction costs and risk premia. Stock prices are therefore characterized as following a random walk, and hence  We are very grateful to Pok-sang Lam for kindly supplying the data, and to an anonymous referee for use- ful comments. The second author gratefully acknowledges financial support from the European TMR Grant No. ERBFMRX-CT-98–0213. The usual disclaimer applies. ∗ Corresponding author. Tel.: +44-20-7815-7012; fax: +44-20-7815-8226. E-mail address: g.m.caporale@sbu.ac.uk (G.M. Caporale). 1062-9769/02/$ – see front matter © 2002 Board of Trustees of the University of Illinois. All rights reserved. PII:S1062-9769(00)00085-5