Enigmatic Forecasts of Enigmatic Risks

Abstract

Most risks in finance are chronically enigmatic. We cannot deduce them from symmetries,
gauge them precisely, or have confidence that they are stable. Yet capital markets force their
estimation and pricing. The excess volatility, propensity to turbulence, and high trading volumes
of capital markets have long been interpreted as evidence of arbitrary and irrational drivers. Yet
simulations and mathematical analysis show that rational learning about unstable risks induces
those features too. Indeed, a capital market can operate like a single rational mind even when
traders are fiercely competitive. This casts doubts on many presumptions of market irrationality.

Keywords: financial markets, financial forecast, asset pricing, rational expectation, anticipation, uncertainty, probabilities, surprise, information acquisition, behavioral finance

JEL Classification: D840, G120, G170