CHAPTER A PP LI CATI O N Stocks, Rational Expectations, and the Efficient Market Hypothesis 153 The Efficient Market Hypothesis Suppose that a share of Microsoft had a closing price yesterday of $90, but new information was announced after the market closed that caused a revision in the forecast of the price next year to go to $120 If the annual equilibrium return on Microsoft is 15%, what does the efficient market hypothesis indicate the price will go to today when the market opens? (Assume that Microsoft pays no dividends.) Solution The price would rise to $104.35 after the opening P of t R of Pt Pt C R* where R of R* P tof Pt C optimal forecast of the return 15% equilibrium return 15% optimal forecast of price next year price today after opening cash (dividend) payment Thus 0.15 0.15 P t (1.15) Pt Pt Rationale Behind the Theory 0.15 0.15 $120 $120 Pt Pt $120 Pt $120 $104.35 To see why the efficient market hypothesis makes sense, we make use of the concept of arbitrage, in which market participants (arbitrageurs) eliminate unexploited profit opportunities (i.e., returns on a security that are larger than what is justified by the characteristics of that security) There are two types of arbitrage, pure arbitrage, in which the elimination of unexploited profit opportunities involves no risk, and the type of arbitrage we discuss here in which the arbitrageur takes on some risk when eliminating the unexploited profit opportunities To see how arbitrage leads to the efficient market hypothesis, suppose that, given its risk characteristics, the normal return on a security say, Nexen common stock is 10% at an annual rate, and its current price Pt is lower than the optimal forecast of tomorrow s price P oft so that the optimal forecast of the return at an annual rate is 50%, which is greater than the equilibrium return of 10% We are now able to predict that, on average, ExxonMobil s return would be abnormally high, so that there is no unexploited profit opportunity Knowing that, on average, you can earn such an abnormally high rate of return on ExxonMobil because R of R *, you would buy more, which would in turn drive up its current price Pt relative to the expected future price P oft 1, thereby lowering R of When the