7.1 The Theory of Rational Expectations

 7.1 The Theory of Rational Expectations

The direction of price movements (up or down) is indeed random, but price levels are based on the rational expectations of a large number of market participants. 

Prices in those markets help to determine what gets made and what doesn’t, how much gets produced and how, and where and how those goods are sold.

Systematic manipulation of the market was impossible because the bulls and bears competed against each other, each tugging at the price, but ultimately in vain. 

As rational investors learned the tricks of trading, they came to expect hyperbole, false rumors, sham sales. 

In the final analysis, market fundamentals, not the whims of nefarious individuals, determined prices. 

Stock and other securities prices fluctuate due to changes in supply or demand, not because of the machinations of bulls and bears.

“The expectation of an event", creates a much deeper impression upon the exchange than the event itself.

Expectations are paramount, people invest based on what they believe the future will bring, not on what the present brings or the past has wrought, though they often look to the present and past for clues about the future. Rational expectations theory posits that investor expectations will be the best guess of the future using all available information. 

Expectations do not have to be correct to be rational; they just have to make logical sense given what is known at any particular moment. An expectation would be irrational if it did not logically follow from what is known or if it ignored available information. 

For the former reason, investors expend considerable sums on schooling, books, lectures to learn the best ways to reason correctly given certain types of information. 

Investors update their expectations, or forecasts, with great frequency, as new information becomes available, which occurs basically 24/7/365.

If everyone’s expectations are rational, then why don’t investors agree on how much assets are worth? Such differences in valuation are important because they allow trades to occur by inducing some investors to sell and others to buy. 

Investors sometimes have different sets of information available to them. Some investors may have inside information, news that is unknown outside a small circle. 

Investors think of the information they know in common differently because their utility functions differ, different holding periods, and different sensitivities to risk.

Investors use different valuation models, different theories of how to predict fundamentals most accurately and how those fundamentals determine securities prices. 

Financial crises almost always follow asset bubbles. Some investors understand the effect of some ripples more quickly and clearly than others. Investors often have a wide variety of opinions about the value of different assets. 

More mechanically, investors might have different opinions about bond valuations because they must have different views about the applicable discount or interest rate. 

PV=FV/(1+i)n

If this is a one-year zero coupon bond, FV = $1,000, and i = 6%, then the bond price = ($1,000/1.06) = $943.40. But if one believes i = 6.01, then the bond price = ($1,000/1.0601) = $942.51. To understand how investors can value the same stock differently, we must investigate how they value corporate equities.