Then, came the stock market “bubble” of 1999-2000, when catastrophic price adjustments occurred. That study, as well as many others before it, assumed that all shocks to the system would be iid N(0, σ). Feltham and Ohlson apply classical RE methodology to equity pricing, and produce a model of equity pricing which, based upon their assumptions, is unbiased. Sargent follows Muth and applies similar assumptions. Further, asset prices fluctuations over time should either converge to the perfect foresight price where shocks decay or follow a random walk pattern where shocks have permanent impact. In particular, RE predicts that, at any one point in time, asset prices should be the best unbiased estimate of future prices, given the existing information available to market participants.
Based upon those assumptions, Muth and others were able to make a number of predictions regarding price fluctuations over time. In his original formulation of the rational expectations (RE) hypothesis, Muth confined his examination to the special case where: 1) The random disturbances are normally distributed 2) Certainty equivalents exist for the variables to be predicted and 3) The equations of the system, including the expectations formulas, are linear. Study demonstrates a deviation of the predicted rational expectations priceįrom the perfect foresight price and demonstrates that such deviation mayīecome extreme near the end of the excess earnings period, resulting in aĬatastrophic price adjustment when that period comes to an end. Predicted to occurs and the marginal return on equity is expected to revert to Of R > r for approximately N periods, after which a Schumpeterian event S is Proprietary technology which enables it to achieve a marginal return on equity and Ohlson and Jeuttner-Nauroth under the following stylizedįacts: we assume that we are dealing with an all-equity firm with opportunity This study examines the time paths of price underĮxisting valuation models such as Baek etĪl. Pricing models result in some degree of overpricing when compared ex post facto This study demonstrates that when the length of theĮxcess earnings period is not known with certainty, all rational expectations
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