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On risk, rational expectations, and efficient asset markets

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  • Guy V.G. Stevens
  • Dara Akbarian

Abstract

The notion of asset market efficiency -- that market prices "fully reflect" all available information -- requires the operation of mechanisms that rapidly incorporate new information into asset prices. Particularly problematic -- both theoretically and empirically -- has been the case where new information is not widely shared, so-called "strong-form" efficiency. This paper examines the relevance of a mechanism for attaining strong-form efficiency based on knowledgeable investors being willing to take large positions in order to eliminate unexploited profit opportunities. We examine theoretically and empirically, the latter using daily stock market data, the impact of a number of factors on the efficacy of this mechanism: the portfolio size and degree of risk aversion of potential investors, the ability to borrow, and the hedging opportunities provided by the stock market.

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File URL: http://www.federalreserve.gov/pubs/ifdp/1994/478/default.htm
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File URL: http://www.federalreserve.gov/pubs/ifdp/1994/478/ifdp478.pdf
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Bibliographic Info

Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 478.

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Date of creation: 1994
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Handle: RePEc:fip:fedgif:478

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Related research

Keywords: Rational expectations (Economic theory) ; Risk ; Information theory ; Stock market;

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  1. Baesel, Jerome B. & Stein, Garry R., 1979. "The Value of Information: Inferences from the Profitability of Insider Trading," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 14(03), pages 553-571, September.
  2. DeCanio, Stephen J, 1979. "Rational Expectations and Learning from Experience," The Quarterly Journal of Economics, MIT Press, vol. 93(1), pages 47-57, February.
  3. J. Bradford De Long & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, . "Noise Trader Risk in Financial Markets," J. Bradford De Long's Working Papers _124, University of California at Berkeley, Economics Department.
  4. Abel, Andrew B. & Mishkin, Frederic S., 1983. "An integrated view of tests of rationality, market efficiency and the short-run neutrality of monetary policy," Journal of Monetary Economics, Elsevier, vol. 11(1), pages 3-24.
  5. Anderson, Ronald W & Danthine, Jean-Pierre, 1981. "Cross Hedging," Journal of Political Economy, University of Chicago Press, vol. 89(6), pages 1182-96, December.
  6. Cyert, Richard M & DeGroot, Morris H, 1974. "Rational Expectations and Bayesian Analysis," Journal of Political Economy, University of Chicago Press, vol. 82(3), pages 521-36, May/June.
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