Conditions under which Exchange Rate may overshoot Even in the Research Paper

Conditions under which Exchange Rate may overshoot Even in the Presence of Rational Expectations - Research Paper Example    John F. Muth of Indiana University coined the theory of rational expectations in the early sixties. He used the term to describe economic situations under which, the outcome depends on peoples' expectations. For example, as discussed by Sargent J. Thomas (Rational Expectations) "The price of an agricultural commodity depends on how many acres farmers plants, which in turn depends on the price that farmers expect to realize when they harvest and sell their crops". The theory greatly applies to the stock markets around the world, as, if investors expect the price of common stock of a particular company to come down they go on a selling spree and the result is obvious, and when they expect it to go up they buy heavily and hence, the prices spirally. To conclude the cornerstone of the theory, we can suggest that, people behave or take decisions in order to maximize the value of an outcome and they keep getting feedback from the transactions, as to what they expected and what they ac tually received. In this way, their expectations over a period of time tend to stabilize because of the result of the past outcomes. In other words, their expectations become rational. To put the theory in mathematical perspective, let us assume that P* is the equilibrium price (a price at which demand equals supply) in a market, then according to the rational expectations theory (Pe) will be the function of P* + e, where (Pe) is the expected price and e is the random error term, which is independent of P*. (Sargent J. Thomas, Rational Expectations). The theory of rational expectations is often put into practice in many economic as well as finance models. One such execution of the model is related to The Efficient Markets Theory of Stock Prices, which states that there are three forms of the efficient-market hypothesis, namely, weak form, semi-strong form, and strong form (Fischer Donald and Jordan Ronald 540). Weak form, which is also known as the Random-walk theory suggests that there is no purpose of examining the charts as the share pieces fully reflect the historical sequences. Semi-strong form, on the other hand, suggests that current market prices not only reflect the historical chart patterns, but also reflect all the publicly available knowledge, so this kind of information is almost always useless for the analysts and the investors. The theory maintains that as soon as the information is made public, the price plays catch-up and soon starts to reflect the new announcement. Finally, strong form suggests that not only pub licly available information is useless, but also all the information concerning the company is useless, as that will have no impact over the stock price.  

EFFICIENT MARKET HYPOTHESIS Essay Example | Topics and Well Written Essays - 1000 words

EFFICIENT MARKET HYPOTHESIS - Essay Example This proposition states that the markets price of securities such as shares traded in any stock exchange will vary or fluctuate according to the nature of information available to the members of the public. For instance information on company profitability, mergers, acquisition and business combination, dividend declaration and investment project that a firm intends to undertake are some of the information that influence the market price of securities. In addition to definition delineated above, efficient market hypothesis can also be delineated into three different ways, that is, allocative efficiency, operational and information efficiency. Allocative efficiency A market is considered to allocative efficient if it channels its direct savings towards the most efficient prolific project. In this case, if an enterprise is efficient it will find it easier to raise funds and this results to foster of the economy arising from the efficiency (Ogilvie, 2006). Allocative efficiency is perce ived to be at its optimal if savings cannot be a channelled to an enterprise or project that would result to higher economic prosperity. . In order, to achieve allocative efficiency in the financial market , the market should contain a fewer number of financial intermediaries such that funds are allocated directly from savers to users. Operational Efficiency Operational efficiency can be simply delineated in general as the minimization of transaction cost. This efficiency concept relates to the cost of conducting business, or the cost of capital that is the interest cost charged by the lender on money borrowed to the borrower. If the transaction cost is high this usually translates to high cost of using the financial markets. (Elton 2010). Therefore, transaction should always be at its minimum in order to increase operational efficiency especially where there is fair completion between the various market players. In order to increase operational efficiency then there is need to incr ease the number of market players who can be able to participate in the market continuously (Elton 2010). . Information Efficiency Information efficiency relates to extent that the information available to the members of public regarding the future panorama of a security is reflected in the present price of the said security. If all parties have the same information which is reflected in the present price of the security at their disposal then conducting investigation on securities becomes fair to all parties. This levels the playing ground for all market participants, because all the parties have access to same information which also reflected by the security price. Information efficiency is of great significant to financial managers since it indicates the effect of management decision will quickly and accurately be reflected in security prices (Elton 2010). The concept of Efficient market hypothesis is main based on information processing efficiency. It articulates that stock mark ets are proficient if and only if is reflected in security prices accurately and rapidly(Elton 2010). Efficient Market Hypothesis Levels Efficiency Efficient Market Hypothesis efficiency can be divided into 3 different levels: Weak form level of efficiency Weak for level of efficiency indicate that the historical price of securities can be used to articulate the changes in the security prices. According to this level of efficien