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Chapter Six

Chapter Six. THE THEORY OF EFFICIENT CAPITAL MARKETS. Theory of Rational Expectations. V.S. adaptive expectation slow adjustment. Rational expectation (RE) = expectation that is optimal forecast (best prediction of future) using all available information: i.e., RE  X e = X of

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Chapter Six

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  1. Chapter Six THE THEORY OF EFFICIENT CAPITAL MARKETS

  2. Theory of Rational Expectations V.S. adaptive expectationslow adjustment • Rational expectation (RE) = expectation that is optimal forecast (best prediction of future) using all available information: i.e., RE  Xe = Xof • 2 reasons expectation may not be rational • 1. Not best prediction • 2. Not use available information • Rational expectation, although optimal prediction, may not be accurate • Rational expectations makes sense because is costly not to have optimal forecast

  3. Theory of Rational Expectations 若利率傾向保持在某一“正常水準”，則當利率很高時，會預期利率將下跌 但若利率走勢為持續目前水準，則當利率很高時，會預期下期利率仍會很高 • Implications: • 1. If there is a change in the way a variable moves, the way in which expectations of this variable are formed will changes • 2. Forecast errors on average = 0 and are not predictable

  4. Efficient Markets Theory • Rational Expectations implies: • Pet+1 = Poft+1 RETe = RETof (1) • Market equilibrium • RETe = RET* (2) • Put (1) and (2) together: Efficient Markets Theory • RETof = RET* • Current prices in a financial market will be set so that the optimal forecast of a security’s return using all available information equals the security’s equilibrium return.

  5. Efficient Markets Theory • Why Efficient Markets Theory makes sense • If RETof > RET* Pt, RETof • If RETof < RET* Pt, RETof • until RETof = RET* • 1. All unexploited profit opportunities eliminated • 2. Efficient Markets holds even if are uninformed, irrational participants in market • 3.forms: strong form • semi-strong form • weak form

  6. Evidence on Efficient Markets Theory • Favorable Evidence • 1. Investment analysts and mutual funds don't beat the market • 2. Stock prices reflect publicly available info: anticipated announcements don't affect stock price • 3. Stock prices and exchange rates close to random walk. If predictions of ΔP big, RETof > RET* P直到predictable price change≒0 • 4. Technical analysis does not outperform market 過去表現好，不見得未來也會好

  7. Evidence on Efficient Markets Theory • Unfavorable Evidence 1. Small-firm effect: small firms have abnormally high returns 2. January effect: high returns in January 3. Market overreaction • 4. Excessive volatility • 5. Mean reversion • Overview • Reasonable starting point but not whole story Price volatility may be driven by factors other than fundamentals

  8. Implications for Investing • 1. Published reports of financial analysts not very valuable • 2. Should be skeptical of hot tips • 3. Stock prices may fall on good news • 4. Prescription for investor • 1. Shouldn't try to outguess market • 2. Therefore, buy and hold • 3. Diversify with no-load mutual fund Ex. Get rich-quick artist Ex. Ape as investment advisor? Whether 1987 market crash is consistent with rational expectation is still controversial “rational bubble”?

  9. Implications for Investing • Evidence on Rational Expectations in Other Markets • 1. Bond markets appear efficient • 2. Evidence with survey data is mixed • Skepticism about quality of data • 3. Following implication is supported: change in way variable moves, way expectations are formed changes

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