How Rational is the Market? Testing Alternative Hypotheses on Financial Market Equilibrium

Larry Lang, Robert H. Litzenberger and Vicente Madrigal

Rodney L. White Center for Financial Research Working Papers from Wharton School Rodney L. White Center for Financial Research

Abstract: It 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.

References: Add references at CitEc
Citations:

There are no downloads for this item, see the EconPapers FAQ for hints about obtaining it.

Related works:
Working Paper: HOW RATIONAL IS THE MARKET? TESTING ALTERNATIVE HYPOTHESES ON FINANCIAL MARKET EQUILIBRIUM (1990)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:fth:pennfi:21-90

Access Statistics for this paper

More papers in Rodney L. White Center for Financial Research Working Papers from Wharton School Rodney L. White Center for Financial Research Contact information at EDIRC.
Bibliographic data for series maintained by Thomas Krichel ().