Copyright © 2000 Addison Wesley Longman Slide #6-1 Chapter Six THE THEORY OF EFFICIENT CAPITAL MARKETS

Copyright © 2000 Addison Wesley Longman Slide #6-2 Theory of Rational Expectations Rational expectation (RE) = expectation that is optimal forecast (best prediction of future) using all available information: i.e., RE  X e = X of 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 V.S. adaptive expectation  slow adjustment

Copyright © 2000 Addison Wesley Longman Slide #6-3 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 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

Copyright © 2000 Addison Wesley Longman Slide #6-4 Efficient Markets Theory Rational Expectations implies: P e t+1 = P of t+1  RET e = RET of (1) Market equilibrium RET e = RET*(2) Put (1) and (2) together: Efficient Markets Theory RET of = 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.

Copyright © 2000 Addison Wesley Longman Slide #6-5 Why Efficient Markets Theory makes sense If RET of > RET*  P t , RET of  If RET of < RET*  P t , RET of  until RET of = 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 Efficient Markets Theory

Copyright © 2000 Addison Wesley Longman Slide #6-6 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, RET of > 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

Copyright © 2000 Addison Wesley Longman Slide #6-7 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 Evidence on Efficient Markets Theory Price volatility may be driven by factors other than fundamentals

Copyright © 2000 Addison Wesley Longman Slide #6-8 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”?

Copyright © 2000 Addison Wesley Longman Slide #6-9 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