PDF Ebook Market Efficiency, Rational Expectations, and Estimation Risk
An efficient securities market is often described as one in which prices 'fully reflect' all available information. Although mis notion has been formalized in a variety of ways, Fama's (1976, chapter 5) definition has probably been most influential. Fama distinguishes between the probability distribution of futureprices assessed by the 'market,' based on whatever information investors view as relevant, and the 'true' distribution of prices conditional on all existing information. The market is said to be informationally efficient if these distributions are equal. An obvious consequence of efficiency is that expected returns anticipated by market participants equal true expected returns. While this definition ignores potentially important issues like heterogeneous beliefs, it provides a useful framework for thinking about a broad set of asset pricing questions.
Market efficiency relates closely to the 'rational expectations' property introduced by Mum (1961) and required of equilibrium asset prices by Lucas (1978). Indeed, Lucas explicitly equates the rational expectations hypothesis with the assumption that prices fully reflect all available information. In his model, asset prices are a function of current production, whose distribution over time is known by investors. Consumers make investment decisions based, in part, on their expectations of future prices. In this context, rational expectations requires mat the price function implied by consumer behavior (the true price function) is the same as the price function on which decisions are based (the perceived price function). Under these assumptions, equilibrium asset prices satisfy Fama's definition of market efficiency.
As Fama (1970) emphasizes, empirical tests of market efficiency invariably entail a joint hypothesis about the equilibrium process mat generates expected returns. Early auto correlation studies, for example, assume that equilibrium expected returns perceived by investors are constant over time. However, it is now widely recognized that rational expectations equilibria can, and generally will, give rise to persistence in expected returns (LeRoy, 1973; Lucas, 1978). This makes the task of evaluating market efficiency more difficult. Are searcher must judge whether the patterns observed in empirical studies are consistent with those that can be generated by credible models of rational behavior.
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PDF Ebook Market Efficiency, Rational Expectations, and Estimation Risk
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