Chapter Six & Ten THE THEORY OF EFFICIENT CAPITAL MARKETS

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 your expectation may not be rational 1. Not the best prediction 2. Not using all available information

Theory of Rational Expectations Rational expectation, although optimal prediction, may not be accurate Rational expectations makes sense because is costly not to have optimal forecast (best guess)

Implications: –1. Change in the way a variable moves, leads to changes in the way expectations for this variable are formed –2. Forecast errors on average = 0 and are not predictable Theory of Rational Expectations

Efficient Markets Theory Mathematical Representation of Return

Efficient Markets Theory Rational Expectations implies: P t+1 = P of t+1  RET e = RET of (1) Market equilibrium RET e = RET*(2) (where RET* is the equilibrium return) Put (1) and (2) together: Efficient Markets Theory RET of = RET*

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 Efficient Markets Theory

Valuation in Efficient Markets Theory The Capital Asset Pricing Model (CAPM) –An Statistical Model used in estimating the expected return of a security –Also used to explain stock return behavior –In basic form this is the Security Market Line (SML) and its corresponding slope we call Beta Arbitrage Pricing Theory –Similar to the CAPM but uses a multi factor framework which includes broader investment and macro economic variables

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*  predictions of ΔP small –4.Technical analysis does not outperform market

–Unfavorable Evidence 1. Small-firm effect: small firms have abnormally high returns 2. January effect: high returns in January 3. Market overreaction (to news or information) 4. Excessive volatility (more fluctuation than dividends warrant) 5. Mean reversion (poor stocks may tend to do better in time) This is often time referred to as Contrarian Investing –Reasonable starting point but not whole story Evidence on Efficient Markets Theory

Implications for Investing Published reports of financial analysts not very valuable Should be skeptical of hot tips Stock prices may fall on good news Prescription for investor 1. Shouldn't try to outguess market 2. Therefore, buy and hold 3. Diversify with no-load mutual fund

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 the way a variable moves, leads to changes in the way expectations for this variable are formed

Implications for Investing The Moral Of The Story In order to maximize returns over the long run we should put our money in market indexed mutual funds S&P 500 Index Funds Total Bond Market Funds REIT Index Funds