Lecture 15: Rational expectations and efficient market hypothesis Mishkin Ch 7 – part B page 156-177

Review Stock basics Stock pricing – from fundamentalists’ view shareholder’s rights; payoffs and liability; stock exchanges and quotes; ways to predict stock price Stock pricing – from fundamentalists’ view current stock price (value today) = PV of all future cash flows

Stock pricing models One-period Generalized: Gordon growth model: assume ‘no bubble condition’: Gordon growth model: assume constant g assume g < ke Under what conditions could you apply pricing models above?

Theory of rational expectations Rational expectation says: Expectation/belief/guess (Xe) is equal to optimal forecast/best prediction of future using all available information (Xof) :

Theory of rational expectations A rational expectation is not necessarily perfectly accurate. It takes too much effort to make the expectation the best guess possible. Best guess will not be accurate because predictor is unaware of some relevant information.

Two forms of rational expectations Weak-Form Rational Expectations: Whatever information people have, they make optimal use of this information in forming their expectations. (Note: No restriction placed on information.) Strong-Form Rational Expectations People have access to all available information about the structure of the world in which they live; (Note: Strong restriction placed on information.) They make optimal use of this information in forming their expectations. Thus, their expectations will be correct up to unsystematic (unavoidable) errors.

Implications of strong form RE If there is a change in the way a variable moves, the way in which expectations of the variable are formed will change as well. The forecast errors of expectations will, on average, be zero and cannot be predicted ahead of time.

Efficient market hypothesis (EMH) Efficient market hypothesis (EMH) is an application of rational expectations theory in financial markets. Efficient market hypothesis (EMH) has three forms.

Efficient market hypothesis - 1 Rate of return and expected rate of return are: Assume ‘rational expectation’ about future price Efficient market hypothesis (form 1, weakest): expectations in financial markets are equal to optimal forecasts using all available information.

Efficient market hypothesis - 2 Efficient market hypothesis (form 2, stronger): current prices in a financial market will be set so that the optimal forecast of return rate using all available information equals the equilibrium return rate. In an efficient market, a security’s price fully reflects all available information

Rationale Prices will adjust until all perceived unexploited economic profits are eliminated – ‘no-arbitrage’ This price adjustment can take place even if there are uninformed irrational participants as long as enough investors (arbitragers) recognize and act to exploit any profit opportunities that arise.

Efficient market hypothesis - 3 Efficient market hypothesis (form 3, strongest): prices reflect true fundamental (intrinsic) value, meaning there are no “price bubbles” on security prices.

Implications of EMH Published reports of financial analysts are not very valuable. Should be skeptical of hot tips because it may probably already contained in the price of the stock. Stock prices respond to announcements only when the information is new and unexpected  stock prices might fall on good news. Shouldn’t try to outbid the market. A “buy and hold” strategy is the most sensible strategy for the small investor.

Evidence in favor of MEH Investment analysts and technical analysis does not persistently beat the market. Stock prices appear to reflect publicly available information: anticipated announcements do not appear to affect stock prices. Having performed well in the past does not indicate that the investor will perform well in the future. If information is already publicly available, a positive announcement does not, on average, cause stock prices to rise Stock prices follow a random walk

Evidence against EMH Small-firm effect January effect Small firms have abnormally high returns January effect Abnormal price rise from December to January (small firms) Market overreaction to news announcements Excessive stock price volatility relative to fluctuations in fundamental value Mean reversion New information is not always immediately incorporated into stock prices

Recap Rational expectations theory (RE theory) Efficient Market Hypothesis (EMH) Three forms Implications Evidence in favor of EMH Evidence against EMH