The Theory of Capital Markets

Rational Expectations and Efficient Markets

Adaptive Expectations

• 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.

“Non-rational” 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.

• The forecast errors of expectations will on average be zero and cannot be predicted ahead of time.– The forecast errors of expectations are

unpredictable.

Efficient Markets• Efficient markets theory is the application of

rational expectations to the pricing of securities in financial markets.– Current security prices will fully reflect all

available information because in an efficient market all unexploited profit opportunities are eliminated.

• The elimination of all unexploited profit opportunities does not require that all market participants be well informed or have rational expectations.

Efficient Markets

RET = Pt+1 – Pt + CPt

RETe = Pe t+1 – Pt + C

Pt

Pet+1 = Pof

t+1 which means RETet+1 = RETof

t+1

RETe = RETof = RET eq

Current prices are set so that the optimal forecast of RET equalsthe equilibrium RET.

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.

Efficient Markets: Theory

• If RETof > RETeq, demand for the asset rises and the current price of the asset rises, causing RETof to fall until it equals RETeq.• RETeq < RETof = (Pof

t+1 – Pt) Pt up RETof down Pt

Efficient Markets: Theory

• If RETof < RETeq, demand for the asset falls and the current price of the asset falls, causing RETof to rise until it equals RETeq.• RETeq > RETof = (Pof

t+1 – Pt) Pt down RETof up

Pt

Efficient Markets: Summary

• RETof > RETeq Price rises RETof falls

• RETof < RETeq Price falls RETof rises

• 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.

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.

– They think they can get a higher price in the future.

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 theory of rational expectations states that expectations will not differ from optimal forecasts using all available information.

• Efficient markets theory is the application of rational expectations to the pricing of securities in financial markets.

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.