The Theory of Capital Markets Rational Expectations and Efficient Markets

Adaptive Expectations –Expectations depend on past experience only. Expectations are a weighted average of past experiences. Expectations change slowly over time.

Rational Expectations The theory of rational expectations states that expectations will not differ from optimal forecasts using all available information. –It is reasonable to assume that people act rationally because it is is costly not to have the best forecast of the future.

Rational Expectations Rational expectations mean that expectations will be identical to optimal forecasts (the best guess of the future) using all available information, but….. –It should be noted that even though a rational expectation equals the optimal forecast using all available information, a prediction based on it may not always be perfectly accurate.

“Irrational” Expectations? There are two reasons why an expectation may fail to be rational: –People might be aware of all available information but find it takes too much effort to make their expectation the best guess possible. –People might be unaware of some available relevant information so their best guess of the future will not be accurate.

Rational Expectations: Implications If there is a change in the way a variable moves, there will be a change in the way expectations of this variable are formed. Therefore, the forecast errors of expectations will on average be zero and cannot be predicted ahead of time.

Rational Expectations and Monetary Policy

Policy Ineffectiveness Proposition According to the rational expectations hypothesis, macroeconomic policy actions that individuals and firms anticipate have no effects on real variables such as output and employment. Only unanticipated policy actions that people cannot predict in advance can influence real GDP and employment.

Rational Expectations Hypothesis Let people’s expectation of the price level, P exp, depend in part on their expectation of how the government will change the money supply, government spending, and taxes. Also assume that people can anticipate government policy with a great deal of accuracy.

Rational Expectations Hypothesis Expansionary monetary policy actions cause an increase in aggregate demand. If people correctly forecast those policy actions, then they fully anticipate the change in the price level that the actions will induce. As price expectations change, people’s wage demands change, causing an offsetting change in aggregate supply.

Rational Expectations Hypothesis AD 2 AD 1 AS 1 AS 2 Y 1 Y P P2P2 P1P1 Rational expectations cause offsetting changes in AS given a change in AD. P rises but Y remains constant. Anticipated Policy Changes 0 1 2

Unanticipated Policy Changes If people do not correctly forecast the government’s policy actions, then they do not correctly forecast the change in the price level induced by the policy change. In this case, as the price level rises output increases along the aggregate supply curve.

AD 2 AD 1 AS Y 1 Y 2 Y P P1P1 Unanticipated Policy Changes P2P2 Only unanticipated policy changes result in a change in output Unanticipated Policy Changes

Rational Expectations: Conclusions The development of rational expectations ignited a major controversy among economists because the model yielded an implication of policy ineffectiveness that directly challenged the mainstream view that active fiscal and monetary policies are needed to moderate the inherent instability of a market economy.

Rational Expectations: Conclusions The research on expectations that followed the introduction of rational expectations increasingly supported the rapid expectations adjustment implied by rational expectations over the sluggish adjustment of adaptive expectations. This suggested that misperceptions would disappear so quickly that there was no time for countercyclical policies to be implemented.

Rational Expectations: Conclusions Ultimately, a consensus was reached that the key issue is not how expectations are formed, but whether changing expectations are really the only important source of output fluctuations. A series of statistical studies showed that the rational expectations model of the business cycle could not account for the observed slower responses of real world economies.

Conclusions: Summary Although early rational expectations models seemed to suggest that active fiscal and monetary policies were not effective. Further research demonstrated that the rational expectation models could not explain the slow response of real world economies to shocks. New approaches rely on underlying sources of friction in the market clearing process to explain business cycles.

Efficient Markets Hypothesis

Efficient Markets The efficient markets hypothesis states that securities are typically in equilibrium or that they are fairly priced. –Current security prices fully reflect all available information because in an efficient market all unexploited profit opportunities are eliminated.

Efficient Markets Theory Weak Version –All information contained in past price movements is fully reflected in current market prices. In this case, information about recent trends in stock prices would be of no use in selecting stocks. “Tape watchers” and “chartists” are wasting their time.

Efficient Markets Theory Semi- Strong Version –Current market prices reflect all publicly available information. In this case, it does no good to pore over annual reports or other published data because market prices will have adjusted to any good or bad news contained in those reports as soon as they came out. Insiders, however, can make abnormal returns on their own companies’ stocks.

Efficient Markets Theory Strong Version –Current market prices reflect all pertinent information, whether publicly available or privately held. In an efficient capital market, a security’s price reflects all available information about the intrinsic value of the security. Security prices can be used by managers of both financial and non-financial firms to assess their cost of capital accurately.

Efficient Markets: Strong Version Security prices can be used to help make correct decisions about whether a specific investment is worth making. In this case, even insiders would find it impossible to earn abnormal returns in the market. –Scandals involving insiders who profited handsomely from insider trading helped to disprove this version of the efficient markets hypothesis.

Efficient Markets Theory: Example Assume you own a stock that has an equilibrium return of 10%. Also assume that the price of this stock has fallen such that the return currently is 50%. –Demand for this stock would rise, pushing its price up, and yield down. Demand and price would rise until RET of = RET eq

Efficient Markets: Theory RET of > RET* Price rises RET of falls to RET* RET of < RET* Price falls RET of rises to RET* In an efficient market, all unexploited profit opportunities are eliminated.

Rational Expectations: Demand and Supply RET of > RET* Price Yield SS P* P 1 P* i * i of i * D2D2 D1D1 D1D1 D2D2 Stock RET of < RET*

Efficient Markets: Example Let the initial price and the expected price of stock A be $100. Also, let the dividend paid equal $15, thereby providing an initial return of 15%. Assume that 15% is the equilibrium return. Let higher profit expectations cause the expected price of stock A to rise to $115 and solve for the new price. RET = (P t+1 – P t + D)/P t 0.15 = ($115 – P t + $15)/P t 0.15 = ($130 – P t )/P t 0.15P t = $130 – P t 0.15P t + P t = $130 P t (1.15) = $130 P t = $130/1.15 = $ Price rises to $113.04, where given the expected price of $115, the expected return is at equilibrium and equal to 15%.

Stock Market Equilibrium Evidence suggests that stocks, especially those of large companies, adjust rapidly to disequilibrium situations. –Equilibrium ordinarily exists for any given stock. Required and expected returns are equal.

Stock Market Equilibrium Stock prices do change and sometimes violently and rapidly. –This reflects changing conditions and expectations. Occasionally, stock prices react for several months to developments. –This is not a long adjustment period, but rather the market responding to new information.

Efficient Markets Hypothesis: Summary The efficient markets hypothesis is a theory of the financial markets that argues that security prices tend to: –Fluctuate randomly around their intrinsic values –Return quickly to equilibrium –Fully reflect the latest information available

The Crash of 1987 The stock market crash of 1987 convinced many financial economists that the stronger version of the efficient markets theory is not correct. –It appears that factors other than market fundamentals may have had an effect on stock prices. This means that asset prices did not reflect their true fundamental values.

The Crash of 1987 But, the crash has not convinced these financial economists that rational expectations was incorrect. –Rational Bubbles A bubble exists when the price of an asset differs from its fundamental market value. –In a rational bubble, investors can have rational expectations that a bubble is occurring, but continue to hold the asset anyway.

Efficient Markets: Evidence Pro: –Performance of Investment Analysts and Mutual Funds Generally, investment advisors and mutual funds do not “beat the market” just as the efficient markets theory would predict. –The theory of efficient markets argues that abnormally high returns are not possible.

Efficient Markets: Evidence Pro: –Random Walk Future changes in stock prices should be unpredictable. –Examination of stock market records to see if changes in stock prices are systematically related to past changes and hence could have been predicted indicates that there is no relationship. –Studies to determine if other publicly available information could have been used to predict stock prices also indicate that stock prices are not predictable.

Efficient Markets: Evidence Pro: –Technical Analysis The theory of efficient markets suggests that technical analysis cannot work if past stock prices cannot predict future stock prices. –Technical analysts predict no better than other analysts. –Technical rules applied to new data do not result in consistent profits.

Efficient Markets: Evidence Con: –Small Firm Effect Many empirical studies show that small firms have earned abnormally high returns over long periods. –January Effect Over a long period, stock prices have tended to experience an abnormal price rise from December to January that is predictable.

Efficient Markets: Evidence Con: –Market Overreaction Recent research indicates that stock prices may overreact to news announcements and that the pricing errors are corrected only slowly. –Excessive Volatility Stock prices appear to exhibit fluctuations that are greater than what is warranted by fluctuations in their fundamental values.

Efficient Markets: Evidence Con: –Mean Reversion Stocks with low values today tend to have high values in the future. Stocks with high values today tend to have low values in the future. –The implication is that stock prices are predictable and, therefore, not a random walk.

Efficient Markets Theory: Implications Hot tips cannot help an investor outperform the market. –The information is already priced into the stock. Hot tip is helpful only if you are the first to get the information. Stock prices respond to announcements only when the information being announced is new and unexpected.

Conclusions: The evidence on efficient markets theory is mixed, but the theory suggests that hot tips, investment advisers’ published recommendations, and technical analysis cannot help an investor outperform the market. The 1987 crash convinced many economists that the strong version of the efficient markets hypothesis was not correct.