How Rational is the Market? Testing Alternative Hypotheses on Financial Market Equilibrium
AbstractIt is widely recognized that heterogeneous information across traders plays an important role in generating financial market activity. However, the predictions of any model of financial markets depend completely on the equilibrium concept used to solve the model. The choice of equilibrium subsumes assumptions and implications concerning: the degree to which traders make use of price as information, the amount of noise trading in the market, the information content of prices, the effect on prices of differences in beliefs, etc. An empirical analysis of equilibrium formation serves as an implicit test of the relative importance of these different properties. We devise tests that distinguish between competitive (Walrasian), fully revealing rational expectations, and noisy rational expectations equilibria based on their comparative static predictions concerning trading volume around public information signals. These tests are implemented using data on stock market trading volume, price changes, and changes in analysts’ earnings forecasts around interim earnings announcements. Empirical results strongly support the noisy rational expectations hypothesis. This indicates that a significant amount of noise trading exists (so that private information has value) but not enough to obfuscate entirely the information content of price. Our analysis also indicates that the dispersion of private information across traders has an impact on trading volume, but not on price. Finally, we explore the implications of our results for asset pricing and volatility, as well as for certain "anomalous" phenomena observed in financial markets.
Download InfoTo our knowledge, this item is not available for download. To find whether it is available, there are three options:
1. Check below under "Related research" whether another version of this item is available online.
2. Check on the provider's web page whether it is in fact available.
3. Perform a search for a similarly titled item that would be available.
Bibliographic InfoPaper provided by Wharton School Rodney L. White Center for Financial Research in its series Rodney L. White Center for Financial Research Working Papers with number 21-90.
Date of creation:
Date of revision:
Contact details of provider:
Postal: 3254 Steinberg Hall-Dietrich Hall, Philadelphia, PA 19104-6367
Phone: (215) 898-7616
Fax: (215) 573-8084
Web page: http://finance.wharton.upenn.edu/~rlwctr/
More information through EDIRC
Other versions of this item:
- Lang, L.H.P. & Litzenberger, R.H. & Madrigal, V., 1990. "How Rational Is The Market? Testing Alternative Hypotheses On Financial Market Equilibrium," Weiss Center Working Papers 21-90, Wharton School - Weiss Center for International Financial Research.
You can help add them by filling out this form.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Thomas Krichel).
If references are entirely missing, you can add them using this form.