Rational Investors or Rational Expectations in Efficient Market Hypothesis?

Magdalena Mikolajek-Gocejna, Tomasz Urbas
International Journal of Finance, Insurance and Risk Management, Volume 13, Issue 2, 167-188, 2023
DOI: 10.35808/ijfirm/360


Purpose: The main goal of this research is to determine whether the tests of the Effecient Market Hypothesis, accepting the neoclassical rationality of investors, can be carried out on data (prices, rates of return) only from the immediate market Design/Methodology/ Approach: The article defines a valuation model by rational investors in which market information is constantly updated and used to determine current and future stock prices. Valuations are made using the Discounted Cash Flow (DCF) method, which is the neoclassical core of financial theory. Expected future prices are a continuous function of time (current research focuses on current value with discrete time analysis). The model was used to test the validity of the efficient market hypothesis (EMH) based on historical and current market price data. Findings: Incorporation of neoclassical investor rationality leads to the conclusion that EMH tests based only on past and present data may give erroneous results. Bypassing investors’ expectations about future makes it difficult to see a possible new price trend created by the arrival of new informatoion to capital market. This may result in incorrect assumptions about the randomness of immadiate market price deviations (return rates) from equilibrium and not to mention that prices contain new information. Then, over time, consecutive instantaneous prices spread around a new but unaddressed trend may be mistakenly assessed as non-random deviating from the trend so far, which may result in the market becoming ineffective in information, despite its information efficiency. Excluding from EMH testing expected future value of the variables is contrary to the principle of investor rationality. Moreover, the deletion of forward data makes it impossible to see the long-term price trend. This distorts the established short-term trend, in particular for spot prices ending the trial. Due to the disturbance in the estimation of the trend, the parameters of random deviations, including autocorrelation, change. This may lead to a faulty conclusion about the market efficiency and the correctness of the asset pricing model. Practical Impications: The tests of the efficient market hypothesis, according to the principle of investor rationality, should take into account the future data held by investors, for example included in forward market prices, or published forecasts of fundamental values. Originality/Value: The obtained results inspire further research into the trends of stock prices and the characteristics of the random noise of prices which are of a rational nature. Deviations from the rational model may constitute a measure of the investor's irrationality and market information inefficiency. This will be the subject of subsequent publications.

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