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ECON 310 C01 Money & Banking J. Scott Sperling Fall 2001 [email protected]
Rational Expectations and Efficient Markets †
1 Rational Expectations
If you look back over what we have covered so far in the course, you might notice that expecta- tions play a large role in financial markets. But how do market participants form their expecta- tions? At one time it was thought that market participants used past information to form their expectations; this is known as adaptive expectations. The problem with adaptive expectations is that participants can only change their expectations slowly, over time.
rational expectations : expectations equal the optimal forecast of prices using all available information
When market participants use all available information, we say that they are rational, or have rational expectations. That is, they not only use past information, but also their future expecta- tions and predictions. Thus, when expectations are rational, the market price of an asset is the best guess of the asset’s fundamental value, i.e. the present value of the expected future returns. This does not mean that the forecast will always be correct, that is to say that there is always some unforecastable error when predicting the future. Another way to say it is that if you have the same information as everyone else in the market, you cannot predict their mistakes because your prediction will be the same as theirs.
2 The Efficient Markets Hypothesis
When we apply rational expectations to the pricing of assets in the market, we get the efficient markets hypothesis. The hypothesis states that when traders and investors use all available in- formation (and transaction costs are low), the equilibrium price of an asset is equal to the market’s optimal forecast of the fundamental value of the asset. Thus, the market price offers participants information for making economic and financial decisions.
2.1 Asset Pricing and Price Fluctuations
We can represent an assets expected price mathematically as:
Pt =
Det+1 + P (^) te+ 1 + i
†If you find any errors or have any questions about these notes, please email me at [email protected].
ECON 310 C01, Fall 2001 Rational Expectations and Efficient Markets Page 2 of 3
where
Pt = price at time t, Det+1 = expected dividend, coupon payment, etc. at time t + 1, i = risk adjusted interest rate, and P (^) te+1 = expected price at time t + 1.
Looking at equation (1) we can see that an asset will have a higer price if it is expected to higher returns, ↑ De, it is expected to rise in value, ↑ P e, or it is not very risky, ↓ i.
If you’re watching CNBC or reading The Wall Street Journal you might notice that prices seem to fluctuate a lot. When prices change, according to EMH, they are representing changes in fun- damental value. So what can cause these changes? Expectations are updated with new news, prices change as a reaction to the news and changes in expected returns, risk, liquidity, interest rates, and so on. Note that news about short-term fluctuations only slightly affect prices, but news about long-term prospects can create large swings.
2.2 EMH and Investment Strategy
Using EMH we can say a few things about different investment strategies.
If all participants have the same information, then all super-normal profits will be traded away, so the only time you should risk your money on a single asset is when you have information superior to the market (usually this involves insider information). Since it is unlikely that you will have superior information, EMH posits that investors should hold a diversified portfolio.
Again, if prices reflect all available information, heavy trading is not a profitable strategy (unless you have superior information). Remember that every trade incurs a transaction cost, so churn- ing your portfolio incurs high transactions costs. Thus, a buy and hold strategy of a diversified portfolio is a better strategy.
EMH implies that technical analysis and “hot tips” will not be a profitable strategy either, since the market price already reflects all available information. This can be shown by the results of top financial managers picks versus the stock picks chosen by darts thrown at The Wall Street Journal. This is not to say that you cannot “beat” the market by uncovering new information however. In fact, it is impossible to predict the price of a stock tomorrow (EMH implies that prices follow a random walk). Only news (new information) will affect the price.
2.3 Are markets efficient?
One argument agains EMH is the “small-firm effect.” Assets of small firms seem to have made an above-normal profit since the mid-1920’s. A second argument against EMH is the “January effect.” The January effect results from a number of investors selling assets in December for tax
