Abstract
AbstractMacroeconomic models that are based on either the rational expectations hypothesis (REH) or behavioral considerations share a core premise: All future market outcomes can be characterized ex ante with a single overarching probability distribution. This paper assesses the empirical relevance of this premise using a novel data set. The authors find that Knightian uncertainty, which cannot be reduced to a probability distribution, underpins outcomes in the stock market. This finding reveals the full implications of Robert Shiller’s ground-breaking rejection of the class of REH present-value models that rely on the consumption-based specification of the risk premium. The relevance of Knightian uncertainty is inconsistent with all REH models, regardless of how they specify the market’s risk premium. The authors’ evidence is also inconsistent with bubble accounts of REH models’ empirical difficulties. They consider a present-value model based on a New Rational Expectations Hypothesis, which recognizes the relevance of Knightian uncertainty in driving outcomes in real-world markets. Their novel data is supportive of the model’s implications that rational forecasting relies on both fundamental and psychological factors.
Highlights
In his classic book Risk, Uncertainty, and Profit, Frank Knight introduced a distinction between measurable uncertainty, which he called “risk,” and “true uncertainty,” which cannot “by any method be reduced to an objective, quantitatively determined probability” (Knight, 1921, p. 321).Over the last four decades, macroeconomists and finance theorists have developed models that assume away Knightian uncertainty and represent the process underpinning outcomes over an indefinite future with a single, overarching probability distribution.1 A vast majority of these models rely on the rational expectations hypothesis (REH) to represent the forecast of the market
We find that psychological factors matter in ways that are consistent with New Rational Expectations Hypothesis (NREH): market participants rely on them
Direct evidence concerning factors driving market participants’ forecasts of dividends and interest rates enables us to assess the empirical relevance of the NREH present-value model, regardless of the particular partly open specification for these outcomes chosen by an economist
Summary
In his classic book Risk, Uncertainty, and Profit, Frank Knight introduced a distinction between measurable uncertainty, which he called “risk,” and “true uncertainty,” which cannot “by any method be reduced to an objective, quantitatively determined probability” (Knight, 1921, p. 321). Direct evidence concerning factors driving market participants’ forecasts of dividends and interest rates enables us to assess the empirical relevance of the NREH present-value model, regardless of the particular partly open specification for these outcomes chosen by an economist. Frydman and Goldberg (2015) show that recognizing Knightian uncertainty does not alter one of the main qualitative predictions of the present-value model: when news about fundamental factors raises (lowers) the market’s forecast of dividends, or lowers (raises) its forecast of the discount rate, the market bids stock prices up (down). A Data Appendix discusses Mangee’s (2011) data and provides examples of his rule-based scoring of market wraps
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