THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 183

CHAPTER 7

Stocks, Rational Expectations, and the Efficient Market Hypothesis

151

it by 5 minutes. Rational expectations theory implies that this is exactly what Joe
will do because he will want his forecast to be the best guess possible. When
Joe has revised his forecast upward by 5 minutes, on average, the forecast error
will equal zero so that it cannot be predicted ahead of time. Rational expectations theory implies that forecast errors of expectations cannot be predicted.

THE EF FI CI EN T M ARKE T HYP OT HE SIS: RATI O NA L
EXP E CTAT I ON S IN FI N AN CIA L MA RKET S
While the theory of rational expectations was being developed by monetary economists, financial economists were developing a parallel theory of expectation formation in financial markets. It led them to the same conclusion as that of the
rational expectations theorists: expectations in financial markets are equal to optimal forecasts using all available information.3 Although financial economists gave
their theory another name, calling it the efficient market hypothesis, in fact their
theory is just an application of rational expectations to the pricing of not only
stocks but other securities.
The efficient market hypothesis is based on the assumption that prices of securities in financial markets fully reflect all available information. You may recall from
Chapter 4 that the rate of return from holding a security equals the sum of the capital gain on the security (the change in the price), plus any cash payments, divided
by the initial purchase price of the security:
R
where

R
Pt

1

Pt
C

Pt
Pt

Pt +1

C

(9)

rate of return on the security held from time t to t 1 (say, the
end of 2010 to the end of 2011)
price of the security at time t 1, the end of the holding period
price of the security at time t, the beginning of the holding
period
cash payment (coupon or dividend payments) made in the
period t to t 1

Let s look at the expectation of this return at time t, the beginning of the holding period. Because the current price Pt and the cash payment C are known at the
beginning, the only variable in the definition of the return that is uncertain is the
price next period, Pt 1.4 Denoting the expectation of the security s price at the end
of the holding period as P te 1, the expected return R e is:
Re

P et

1

Pt
Pt

C

3

The development of the efficient market hypothesis was not wholly independent of the development
of rational expectations theory, in that financial economists were aware of Muth s work.

4

There are cases where C might not be known at the beginning of the period, but that does not make
a substantial difference to the analysis. We would in that case assume that not only price expectations
but also the expectations of C are optimal forecasts using all available information.