Restrictions on Asset-Price Movements Under Rational Expectations: Theory and Evidence
87 Pages Posted: 13 Aug 2019 Last revised: 25 Jan 2022
Date Written: January 20, 2022
How restrictive is the assumption of rational expectations in asset markets? To address this, we derive bounds on admissible asset-price variation under general assumptions. The challenge in this task is that valuations reflect both beliefs and preferences. We gain traction by considering market-implied, or risk-neutral, probabilities of future outcomes, and we provide a mapping between the variation in these probabilities and the minimum risk aversion — or slope of the stochastic discount factor — required under rationality. Implementing these bounds empirically using index options, we find that very high risk aversion is needed to rationalize the behavior of risk-neutral beliefs.
JEL Classification: D84, G14, G41
Suggested Citation: Suggested Citation