Restrictions on Asset-Price Movements Under Rational Expectations: Theory and Evidence

87 Pages Posted: 13 Aug 2019 Last revised: 25 Jan 2022

See all articles by Ned Augenblick

Ned Augenblick

University of California, Berkeley - Economic Analysis & Policy Group

Eben Lazarus

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Date Written: January 20, 2022

Abstract

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

Augenblick, Ned and Lazarus, Eben, Restrictions on Asset-Price Movements Under Rational Expectations: Theory and Evidence (January 20, 2022). Available at SSRN: https://ssrn.com/abstract=3436384 or http://dx.doi.org/10.2139/ssrn.3436384

Ned Augenblick

University of California, Berkeley - Economic Analysis & Policy Group ( email )

Berkeley, CA 94720
United States

Eben Lazarus (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street, E62-633
Cambridge, MA 02142
United States
6173247036 (Phone)

HOME PAGE: http://elazarus.mit.edu

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