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I am doing spot price forecasting for a market, and so far, the naive forecasting model, which forecasts with the last observed prices, is the best forecasting model. I know that it might be because of my poor forecasting skills; however, how can this situation be explained if it is not the case?

So far, I have come up with two potential explanations:

1-The market is efficient. Therefore, forward contract prices are unbiased estimators of future spot prices. Since forward contract prices are distributed symmetrically around the spot prices under rational expectations, we can say that the last observed spot price is a good predictor for future spot prices.

2-Spot price process behaves like a Martingale. In Martingale, expected future spot prices are equal to the last observed spot price.

I am new to these topics; therefore, I am confused about differentiating the efficient market hypothesis and martingale process. Are these explanations meaningful? Is it possible that both explanations are correct, or only one of them can be right?

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  • $\begingroup$ EMH and Martingale are closely related ideas, really the same idea in different words (at least for short term returns). One is in the vocabulary of Economics, the other occurs in Mathematics of stochastic processes. $\endgroup$
    – nbbo2
    Mar 17, 2022 at 9:55
  • $\begingroup$ Hi: I don't remember the name of it but you may want to look at rational expectations and futures prices. There's a book on it but I can't currently recall the name of it right now. I'll look for it on amazon and, if I find it, I'll put it in another comment. Note that Rational expectations (RE) has a long history in econometrics and could be applicable to your problem. If you're not familar with it, RE is yet another term related to market efficiency but, it's somewhat of a broader term. The book by Pesaran is a very nice econometric introduction to RE but it doesn't cover futures prices. $\endgroup$
    – mark leeds
    Mar 18, 2022 at 12:22
  • $\begingroup$ Here's the book by Pesaran. I'm still looking for the futures book. amazon.com/Limits-Rational-Expectations-Hashem-Pesaran/dp/… $\endgroup$
    – mark leeds
    Mar 18, 2022 at 12:24
  • $\begingroup$ Here's the futures book that I was referring to. Note that I have it somewhere but have never read it. It's a conglomeration of various papers from the literature so it assumes some RE background which you can obtain from Pesaran's text. amazon.com/Rational-Expectations-Efficiency-Futures-Markets/dp/… $\endgroup$
    – mark leeds
    Mar 18, 2022 at 12:26

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