4 - Efficient markets and rational expectations

Summary

The proposition that markets process information efficiently might be controversial for macroeconomic models but has served as the foundation of research in financial markets for some time. The rational expectations hypothesis, under the name of the “efficient-markets model,” has been used quite extensively in financial-market research. The efficient-markets model asserts that prices of securities are freely flexible and reflect all available information. In its more formal statements, the model asserts that prices are related to conditional expectations.

These ideas have become so familiar to economists that they have even filtered down to the introductory level of instruction in the form of the random walk theory. Price changes, it is alleged, must follow random patterns. If past prices or volume played any role in predicting price behavior, then Wall Street technicians would soon discover these patterns. As technicians began to act on their findings, prices would adjust, so the pattern would disappear. For example, if it were predicted that stock prices would rise by 10 percent by the end of the week, investors would rush out and purchase securities until their prices rose by 10 percent. Prices would increase at that time rather than at the end of the week. Thus, no established patterns calculated from past data can ever be used to predict price behavior. Price changes, therefore, must be random.

According to some simple versions of the theory, the price of a security today is equal to the conditional expectation of tomorrow's price.