The efficient index hypothesis and its implications in the BSM model

This note studies the behavior of an index I_t which is assumed to be a tradable security, to satisfy the BSM model dI_t/I_t = μdt + σdW_t, and to be efficient in the following sense: we do not expect a prespecified trading strategy whose value is almost surely always nonnegative to outperform the index greatly. The efficiency of the index imposes severe restrictions on its growth rate; in particular, for a long investment horizon we should have μ\approx r+σ^2, where r is the interest rate. This provides another partial solution to the equity premium puzzle. All our mathematical results are extremely simple.

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