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Optimal forecast
- Rational expectation is the optimal forecast using all the available information but the forecast will not always be right.
- Why? Each forecast has an error that is given by all the possible outcomes.
- But it will be an optimal forecast meaning it will be unbiased.
- Unbiasedness means that there is no bias in any forecast.
Rational Expectation
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If information set θ changes then
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Forecast errors are on average zero
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Efficient Capital Markets
- Efficient markets in finance is less restrictive than the concept of perfect capital markets.
- In an efficient capital market, prices fully and instantaneously reflect all available relevant information – informationally efficient.
- A capital market may be informationally efficient but not allocatively or operationally efficient. E.g. imperfect competition (allocatively inefficient) or transactions costs like the proposed Tobin tax (operationally inefficient).
Efficient Markets Hypothesis
- Expectations are unobserved and we need expectations of future stock price to calculate expected return.
- The theory of rational expectations tells us that expectations are the optimal forecasts based on all the available information.
- The supply and demand for securities will determine an equilibrium price of securities therefore the expected price of stocks will be given by the market equilibrium.
- The expected return on a security will equal the equilibrium return given by the market conditions for that particular security.
Semi-strong form efficiency
- No investor can earn excess returns from trading rules based on any publicly available information.
- Implication is that all publicly available information is fully reflected in the actual asset price.
- Market reaction to new publicly available information is instantaneous and unbiased. No over- or under-reaction. Fundamental analysis based on publicly available information shouldn’t result in abnormal returns.
Strong form efficiency
- No investor can earn excess returns using any
information – public or private.
- Strong form efficiency implies that all
information is fully reflected in the price of the
asset.
- Even private information! – Insider trading is
ineffective
Evidence in favour of EMH
- Empirical studies confirm that stock pickers or mutual fund managers cannot outperform the market over a long period of time.
- The EMH states that stock prices reflect all available information so that earnings announcements that are already known will not affect stock prices when the announcements are made. Only ‘new’ news causes stock prices to change.
- Future changes in stock prices should follow a random walk (future changes in prices are unpredictable).
Random Walk-assume expected dividend
stream is constant
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Empirical evidence against EMH
- Size effect – Empirical studies show that small firms earn abnormal returns over long periods.
- January effect – studies have confirmed an abnormal price rise from December to January.
- Market overreaction – over/under shooting following ‘new’ news.
- Excessive volatility – fluctuations in stock prices are greater than the fluctuations in the fundamentals.
- Mean reversion – low returns stock tend to be followed by high returns and vice versa. Stocks that have done poorly in the past tend to do better in the future. But the evidence on this is controversial.
- Lag in effect of ‘new’ news – stock prices do not always react to news instantly. Some evidence of autocorrelation.
- If capital markets are informationally efficient, why is there so much between people that take different views about the same future.
The final say?
- “Observing correctly that the market was frequently
efficient they [academics, investment professionals, corporate mangers] went on to conclude incorrectly that it was always efficient” Warren Buffet
- “Economics is not so much the Queen of the social
sciences but the servant, and needs to base itself on anthropology, psychology – and the sociology of ideologies” John Kay (FT 7/10/09)
Summary
- The theory of stock market valuation
- Expectations govern the valuation of stocks.
- Different expectations result in different expected returns and a distribution of expected capital gains.
- The theory of rational expectations provides a market equilibrium basis for expectations based on available information.
- The EMH is the application of rational expectations to the securities market.