The Theory of Capital Markets
Rational Expectations and Efficient
Markets
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Adaptive Expectations
• Adaptive Expectations
– Expectations depend on past experience only.
• Expectations are a weighted average of past
experiences.
• Expectations change slowly over time.
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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.
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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.
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“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.
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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.
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Summary Statistics (1926 - 2000)
Large
Company
Stocks
Compound Arithmetic
Annual
Annual
Return
Return
Risk
(Standard
Deviation)
11.2%
13.2%
20.3%
Small
Company
Stocks
12.4%
17.4%
33.8%
Gov’t
Bonds
5.3%
5.7%
9.2%
Cash
3.8%
3.8%
3.2%
Inflation
3.1%
3.2%
4.5%
Distribution of
Annual Returns
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Tulipmania
•
•
•
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Holland, 1630s.
Peter Garber, Famous First Bubbles
Mosaic virus, random-walk look
Free press began in Holland then.
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Dot Com Bubble
• Toys.com: Had disadvantage relative to
bricks & mortar retailers starting web sites
• Lastminute.com: travel agency, sales in
fourth quarter of 1999 were $650,000,
market value in IPO ins March 2000 was $1
billion.
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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.
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Definition of Efficient Markets
(cont.)
• Professor Eugene Fama, who coined the phrase
“efficient markets”, defined market efficiency as
follows:
– "In an efficient market, competition among the many
intelligent participants leads to a situation where, at
any point in time, actual prices of individual securities
already reflect the effects of information based both on
events that have already occurred and on events which,
as of now, the market expects to take place in the future.
In other words, in an efficient market at any point in
time the actual price of a security will be a good
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estimate of its intrinsic value."
The Efficient Markets Hypothesis
• The Efficient Markets Hypothesis (EMH) is
made up of three progressively stronger
forms:
– Weak Form
– Semi-strong Form
– Strong Form
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The EMH Graphically
All historical prices and returns
• In this diagram, the circles
Strong Form
represent the amount of
information that each form
Semi-Strong
of the EMH includes.
• Note that the weak form
Weak Form
covers the least amount of
information, and the
All public information
strong form covers all
information.
• Also note that each
successive form includes
All information, public and private
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the previous ones.
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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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Behavioural Finance
• The lack of short selling (causing
over-priced stocks) may be explained by
loss aversion
• The large trading volume may be explained
by investor overconfidence
• Stock market bubbles may be explained by
overconfidence and social contagion
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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.
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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.
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