Rescuing Rational Expectations from Undeserved Ridicule

Abstract

Heterogeneity of risk aversion parameters of economic agents facilitates risk sharing, as such, is a necessary condition for economic viability of stock markets. This study finds price equilibriums that are outcome of conditioning of homogeneously received information on heterogeneous realizations of risk preferences Pareto dominate alternate comparable equilibriums that are conditioned on the `common' component of heterogeneously received information. Necessity of an information source that is not either of stock prices or stock returns, and that equally is visible to all for feasibility of homogeneously received information establishes necessity of a `market procedural mechanism' for conditioning of rational expectations equilibriums (REE). While stock return volatility has, in context of the `Intertemporal Capital Asset Pricing Model (ICAPM)', structure that is amenable to its characterization as a market procedural mechanism, expectations that are conditioned on stock return volatility explicitly are shown to have character of uninformed gambles. Implicitness of adoption of return volatility as market mechanism suffices then, for inducement of stock markets that are characterized by, `gambles over lotteries'; the `investors trade too much' phenomenon; and intermittency of market correction events. We arrive then at a rational explanation for seeming irrationality or proneness to bias of actions of investors in stock markets, namely absence of a robustly formulated market procedural mechanism for formation of rational expectations equilibriums. In aggregate, we arrive at rescue of concept of REE from undeserved ridicule, that is, infer failings of mechanism design as bane of current workings of stock markets.