Definition of random walk theory

random walk theory

Security prices change randomly, with no predictable trends or patterns.

Random walk

theory that stock price changes from day to day are at random; the changes are independent
of each other and have the same probability distribution. Many believers of the random walk theory believe
that it is impossible to outperform the market consistently without taking additional risk.

Agency theory

The analysis of principal-agent relationships, wherein one person, an agent, acts on behalf of
anther person, a principal.

Arbitrage Pricing Theory (APT)

An alternative model to the capital asset pricing model developed by
Stephen Ross and based purely on arbitrage arguments.

Bubble theory

Security prices sometimes move wildly above their true values.

Continuous random variable

A random value that can take any fractional value within specified ranges, as
contrasted with a discrete variable.

Discrete random variable

A random variable that can take only a certain specified set of discrete possible
values - for example, the positive integers 1, 2, 3, . . .

Liquidity theory of the term structure

A biased expectations theory that asserts that the implied forward
rates will not be a pure estimate of the market's expectations of future interest rates because they embody a
liquidity premium.

Local expectations theory

A form of the pure expectations theory which suggests that the returns on bonds
of different maturities will be the same over a short-term investment horizon.

Market segmentation theory or preferred habitat theory

A biased expectations theory that asserts that the
shape of the yield curve is determined by the supply of and demand for securities within each maturity sector.

Modern portfolio theory

Principles underlying the analysis and evaluation of rational portfolio choices
based on risk-return trade-offs and efficient diversification.

Normal backwardation theory

Holds that the futures price will be bid down to a level below the expected
spot price.

Normal random variable

A random variable that has a normal probability distribution.

Preferred habitat theory

A biased expectations theory that believes the term structure reflects the
expectation of the future path of interest rates as well as risk premium. However, the theory rejects the
assertion that the risk premium must rise uniformly with maturity. Instead, to the extent that the demand for
and supply of funds does not match for a given maturity range, some participants will shift to maturities
showing the opposite imbalances. As long as such investors are compensated by an appropriate risk premium
whose magnitude will reflect the extent of aversion to either price or reinvestment risk.

Pure expectations theory

A theory that asserts that the forward rates exclusively represent the expected
future rates. In other words, the entire term structure reflects the markets expectations of future short-term
rates. For example, an increasing sloping term structure implies increasing short-term interest rates. Related:
biased expectations theories

Random variable

A function that assigns a real number to each and every possible outcome of a random experiment.

Randomized strategy

A strategy of introducing into the decision-making process a random element that is
designed to reduce the information content of the decision-maker's observed choices.

Static theory of capital structure

theory that the firm's capital structure is determined by a trade-off of the
value of tax shields against the costs of bankruptcy.

theory of constraints (TOC)

a method of analyzing the bottlenecks
(constraints) that keep a system from achieving
higher performance; it states that production cannot take
place at a rate faster than the slowest machine or person
in the process

expectations theory of exchange rates

theory that expected spot exchange rate equals the forward rate.

pecking order theory

Firms prefer to issue debt rather than equity if internal finance is insufficient.

trade-off theory

Debt levels are chosen to balance interest tax shields against the costs of financial distress.

Quantity Theory of Money

theory that velocity is constant, and so a change in money supply will change nominal income by the same percentage. Formalized by the equation Mv = PQ.

Real Business Cycle Theory

Belief that business cycles arise from real shocks to the economy, such as technology advances and natural resource discoveries, and have little to do with monetary policy.

Random-location storage

The technique of storing incoming inventory in any
available location, which is then tracked in a locator file.

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