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

Xe = Xof

•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

t

te1te

t

t1t

P

CPPRET

P

CPP RET

• Mathematical Representation of Return

Efficient Markets Theory

• Rational Expectations implies:Pt+1 = Pof

t+1 RETe = RETof (1)

• Market equilibriumRETe = RET* (2)(where RET* is the equilibrium return)

• Put (1) and (2) together: Efficient Markets Theory

RETof = RET*

• 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

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, RETof > 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 market2. Therefore, buy and hold3. Diversify with no-load mutual fund

Implications for Investing

• Evidence on Rational Expectations in Other Markets1. Bond markets appear efficient2. 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 StoryIn 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