Expectations Hypothesis Research Articles

Monetary Policy Announcements and Stock Returns: Some Further Evidence from India

We inquire into the nexus between monetary policy announcements and stock returns in emerging market economies. Drawing the sample from one of the important emerging economies such as India, we show that the Indian stock market is responsive to unscheduled and unexpected scheduled monetary policy announcements whereas the market was already adapted to the expected component of scheduled announcements. The evidence supports the rational expectation hypothesis. This study also finds the effect of policy change direction and monetary policy announcement as a kind of news (good or bad news) on specific sectoral stock returns. Further, we find banking, financial services and auto sectors are the most prominent in transmitting the objective of the monetary policy. This study documents the repo rate is relatively important monetary policy rate to affects the stock returns and response of sectoral returns vary across the instruments. Overall, the evidence from this study confirms the proposition that monetary policy transmission via stock market is significant.

Investigating the expectation hypothesis and the risk premium dynamics: new evidence for Brazil

We re-examine the validity of the expectation hypothesis (EH) of the term structure for the Brazilian fixed income market, using data from January 2000 to June 2017. Furthermore, we investigated the out-of-sample predictability of bond excess returns by means of common factors extracted from a cross-section of Brazilian macro-variables and zero-coupon interest rates. The EH is rejected throughout the term structure examined on the basis of the statistical tests across the entire maturity spectrum considered. Our results confirm previous findings, mostly obtained for developed markets, that a linear combination of forward rates and macroeconomic factors can explain a substantial portion of movements in bonds excess returns, contributing novel and up-to-date evidence from a large and dynamic emerging bond market, such as Brazil. Furthermore, we find that the factor extracted from a large panel of macroeconomic variables generates significant gains in forecasting bond excess returns relative to yield curve information.

The Winter of our Discontent

The article discusses three reasons for dissatisfaction with regard to the core of contemporary macroeconomics and its inability to conceive the outbreak of the Great Recession. The first comes from the excessive importance given to the demand for microeconomic foundations to the detriment of treating the problem of the aggregation and coordination of individual behaviours, an imbalance that culminates in the frequent recourse to the figure of the representative consumer. The second concerns the usurpation by this same consumer of the role of decision-maker about employment and investment at the expense of firms, simple insignificant automata on markets governed by perfect or monopolistic competition. The third involves the simplistic way in which the rational expectations hypothesis has often been applied, treating agents as observers rather than actors who create the conditions for realizing their own forecasts. These three reasons lead to arguing for a macroeconomic modelling that takes the heterogeneity of agents seriously and restores to far-from-insignificant firms a driving role in the process of making decisions about employment and investment, in a context of strategic interactions.

On Paul Davidson’s Critique of Rational Expectations: Aiming at the Wrong Target Using the Wrong Theoretical Construct for the Wrong Reasons

Paul Davidson’s nearly 40 years long critique of Rational Expectations is centered primarily on his claim that the Rational Expectations Hypothesis was built on a foundation that assumed ergodicity. However, the rational expectations hypothesis is not built on the assumption of ergodicity. The concepts of ergodicity and non-ergodicity belong to the Limiting Frequency interpretation of probability. Rational Expectations was supposed to have been built on the Subjective interpretation of probability. Rational Expectations is built on the claim, originally introduced in 1961 in R. Muth’s Econmetrica article, that the subjective probability distributions, for a given information set, are distributed around a true, correct, objective probability distribution. This assumption is incoherent, inconsistent, incomprehensible, and contradictory because there is no existing theory of probability (Classical, Logical, Propensity, Frequency, Subjective) that allows Subjective probabilities (distributions) to become equal to Objective probabilities (distributions). The only restriction allowed by the subjective theory of probability on the preferences of individual decision makers, which is applicable only at the micro level, is that the probabilities, be they initial or updated, are additive and linear. No other restriction is allowed by the Ramsey-Savage-de Finetti subjective Bayesian theory of probability. Rational expectation advocates, proponents, and practitioners add a very large number of additional restrictions on the subjective preferences of decision makers in order to transform subjective probability into an alleged true, correct, right objective probability (distribution). The fatal Achilles’ Heel of Rational Expectations is that there is no extant probability theory that allows subjective probabilities to be transformed into objective probabilities at the macro level or inter temporally throughout time. Savage made in very clear in 1954 in The Foundations of Statistics (p.16) that such an approach was “utterly preposterous” and “complete nonsense” since, as Bruno de Finetti had pointed out, “(objective) probability does not exist”. Paul Davidson’s critique completely overlooks the fundamental error committed in all theories of rational expectations, which is that at some point in time, subjective probabilities become objective probabilities. Nelson Goodman pointed out an additional, fundamental problem for the rational expectations approach of how this change can be expected to occur in the future, which was equivalent to his grue-bleen problems, where at some point in the future, empirically, well established green objects all of a sudden become blue or empirically, well established blue objects all of a sudden become green. Paul Davidson’s critique of rational expectations is completely and fundamentally flawed because Davidson’s “ergodic-nonergodic” duality has absolutely nothing to do with the rational expectations' hypothesis, which is that the subjective probability distributions are distributed around an objective, true distribution for a given information set.

Developers land sale bidding strategy and house price expectation formation

ABSTRACTThis paper studies developers’ bidding strategy in Hong Kong’s land sale market where aggressive bidding is commonly seen. Given that the difference between the submitted bid and the estimated land value can be explained by the developer’s housing market outlook, the formation of house price expectation represents a tool to understand developers’ bidding strategy. Different economic expectation models are tested. While the rational expectation hypothesis (REH) is rejected, the proposed adaptive implicit expectation model best describes developers’ expectations. The findings in this paper provide land policymakers with insights on controlling the outcome of land sales as well as fill the gap of the house price expectation formation which remains little known.

Is Long Rate Decoupling From Short Rate? Revisiting Expectation Hypothesis Of Australian Term Structure Of Interest Rate

Background and statement of the problem: Previous studies on Australian data provide inconclusive results on expectation hypothesis. Moreover, it is argued that Australian long-term rate is influenced by US long term rate, which signals decoupling of short rate from long rate. This decoupling, if true, makes monetary policy transmission ineffective. Accordingly, the paper examines expectation hypothesis with Australian data. Research methodology and data: Daily, weekly, monthly and quarterly data on 30-day, 90-day and 180-day dealers bill and 5-year and 10-year Australian government bond rate over the period from 1976 to 2016 are sourced from Datastream. Unit root test with structural break is applied to check the stationarity of data. Threshold co-integration approach is followed to test the expectation hypothesis of interest rate. Principal component analysis is used to identify common global factors affecting long rates in developed countries. Finally, Gewek’s instantaneous feedback method is applied to examine contemporaneous movement of long rate in developed countries. Research findings: Empirical analysis shows that all interest rate series are nonstationary at level; however, stationary at their first differences, which are suitable for co-integration analysis. Threshold co-integration results show that short rate and long rate in Australia are co-integrated, that is, expectation hypothesis holds. We also find evidence of threshold effect in some cases. Using principal component and instantaneous feedback method we find that long term bond yields in developed markets are driven by some unobserved global factors and the USA long rate has no causal influence on other developed markets’ long rate. We conclude that in Australia short rate is not de-coupling from long rate and hence effectiveness of monetary policy is well maintained. Policy implications: Expectation hypothesis is essential for the effective transmission of monetary policy. The hypothesis, if does not hold, causes interruption in monetary policy transmission. We find that expectation hypothesis holds for Australian data; hence RBA’s monetary policy transmission should not foresee any interruption. Moreover, bond contains premium for expected inflation, so it can be used as an indicator of RBA’s commitment for low inflation. Besides, financial intermediaries can effectively use the link between short and long rate in setting their interest on long-term loans based on short term interest rates.

Rational Expectations Theorists Rely Completely on the Fallacy of Conditional Apriorism (Long Runism), First Introduced by Charles Sanders Pierce and Hans Reichenbach in Their Objective Limiting Frequency Interpretations of Probability: No Frequentist Hypothesis Test Can Ever Lead to the Acceptance of the Rational Expectations Hypothesis

All Rational Expectation Theorists rely on the Fallacy of Conditional Apriorism (Long Runism)in order to operationalize the Objective Limiting Frequency Interpretation of Probability. However, such a limit only occurs in the far distant long run as the number of observations from Time Series data approached infinity. It is impossible to apply this in the short run because the long run limit, if it exists, is compatible with an infinite number of different answers. Nicholas Rescher demonstrated the nature of this fallacy a number of times in the mid-1970’s to early 1980’s. Standard Frequentist Hypothesis Testing using p-values (R. Fisher) and critical values (Neyman-Pearson) can never led to the acceptance of any hypothesis as true or correct. The only outcomes possible are to Reject the Null Hypothesis at some level of significance or to Do Not Reject the Null Hypothesis at some level of significance. Do Not Reject can never be interpreted as being Accepted, so that the hypothesis is regarded as being True, Right, or Correct. Every application of the Rational Expectations Hypothesis in all academic journal articles is inherently flawed because of the explicit claim that the long run limit can be known in a short period of time. The claim that the long run limit value can be known in the short run by a decision maker is the Fallacy of Conditional Apriorism (Long Runism). The rational expectations hypothesis attempts to claim that decision makers can identify in the short run what the long run limit is based on a faulty learning from experience argument, which is very similar to the same type of argument made by an opponent of the rational expectations hypothesis, Paul Davidson (see the references).Nicholas Rescher had already demonstrated that this is a fallacy. Finally, no amount of Frequentist hypotheses testing can EVER lead one to the conclusion that the rational expectations hypothesis has been accepted as true. Only deductive arguments are true or false, correct or incorrect, right or wrong. Inductive arguments are only more or less probable.

Evolution of New Keynesian Economics

In this article, the developments in the New Keynesian Economics which sprang up in USA during the ‘80s will be discussed and then the properties of the Keynesian Economics in terms of their assumptions and models will be analyzed.New Keynesian Economics is based upon the Keynesian System also considers that when the economy left to itself it will settle at less-than full-equilibrium in the short-run. Even though most of the New Keynesian economists accept rational expectations hypothesis, they refuse the perfect competition conditions and perfect elasticity of prices and wages. Hence the imperfect competition and the rigidities of prices and wages will result in the Keynesian lack-of effective demand as well as coordination failure in the market. For the long run, following the Neo-Keynesian economists, they suggest that the economy will tend towards automatic natural-rate-of-unemployment (nru) equilibrium in the long-run, apart from a few New Keynesian economists who work with Hysteresis and Efficiency Wage models. New Keynesian Economics provide the consistency between the micro- and macro-analysis and seem to be more realistic and valid for the developing countries. The representatives of the New Keynesian Economics are Alan S. Blinder, N. Gregory Mankiw, John Taylor, David Romer.

Reconsidering Rational Expectations and the Aggregation of Diverse Information in Laboratory Security Markets

In a seminal work, Plott and Sunder (1988) offer support for the rational expectations hypothesis and report evidence that markets with certain features aggregate dispersed information. However, their results are based on only a few observations and our attempt to replicate the key findings of that study with an appropriately powered experiment largely fails. The resulting post study probability that market performance is better described by rational expectations than the prior information (Walrasian) model under the conditions specified by Plott and Sunder (1988) is very low. As a result of our failure to replicate, we investigate an alternate set of market features that combines aspects of the original experimental design. For these markets we do find robust evidence of information aggregation in support of the rational expectations model. In total, our results indicate that information aggregation in asset markets is fragile and should only be expected in limited circumstances.

The Overlooked Importance of Benjamin Friedman’s Original, 1979 Critique of the Foundations of Rational Expectations Supplied by Lucas and Sargent: The Fallacy of Long Runism (Conditional a Priorism)

Lucas, Sargent, and all other proponents, advocates, users and supports of the Rational Expectations Hypothesis have overlooked the fact that their claim that decision makers can learn about and apply in the short run knowledge of the long run convergence properties of objective frequency probability distributions, as the number of observations in the series approaches infinity, is problematic. The argument, that they can learn, grasp and apply such long run knowledge and apply it in any short-run period of time, is called the fallacy of long runism (conditional apriorism). Nicholas Rescher demonstrated this repeatedly in work published in the mid to late 1970s. This error was originally made by Charles Sanders Pierce and Hans Reichenbach in their theoretical frequentist approaches to probability. Benjamin Friedman noticed the dependence of the Lucas–Sargent( 1979) claim, that decision-makers can come to know the long run convergence properties of the mechanism that is generating the long run series of observations, knowledge of which can only be learned in the distant, very long run as the limit is approached as the number of observations approaches infinity, about the applicability of the rational expectations hypothesis. Lucas-Sargent sidestepped this criticism by claiming that they could use the Bayesian, Subjective theory of probability as their foundation instead. However, in the early 2000’s, Anderson, Hansen, and Sargent (2003) and Hansen and Sargent (2011) stated that they could not use the subjective theory of probability as the foundation for the Rational Expectations Hypothesis because a large number of restrictions imposed by the rational expectations hypothesis conflicted directly with the theory of subjective probability as developed by L J Savage in 1954. Anderson, Hansen, and Sargent (2003) and Hansen and Sargent (2011) reverted to the claim that the foundation of the Rational Expectations Hypothesis was objective frequentist probability theory. However, they simply repeat the original position published in 1979 by Lucas and Sargent. Benjamin Friedman’s original critique of rational expectations in 1979 is applicable again. The failure of any user, proponent or advocate of the rational expectations hypothesis to demonstrate the forecasting superiority of the rational expectation’s hypothesis over other approaches, through the use of proper scoring rules in the nearly 60 years that have passed since the publication of Muth’s original exposition of the rational expectation’s hypothesis, calls into question the claims made by Lucas and Sargent in 1979 about rational expectations. It is difficult to find a specific theory of probability upon which proponents, advocates, user, or supporters of the rational expectations hypothesis in the literature agree is to be used to support their claims. Currently, the combined use of both subjective and objective theories of probability, which often occurs many times simultaneously in the same literature, fails to recognize that there are no objective theories of probability that recognize any role for subjective probability, and no subjective theories of probability that recognize any role for objective probability. This is most clearly specified by B. de Finetti by his famous saying that “Probability(objective) does not exist.” Rational expectationists have apparently now realized that the subjective theory of probability can’t serve as a foundation for rational expectations. They originally sought to use objective frequentist probability for their foundation until challenged by B. Friedman in 1979. They have now gone back to this foundation but have failed to deal with the objections that were originally leveled in 1979.

Firms’ Expectations on the Availability of Credit Since the Financial Crisis

Using a large set of firm-level survey data from the euro area since 2009, we analyse how firms use their information to form expectations on the availability of bank finance. Our results suggest that firms update what otherwise look like adaptive expectations on the basis of the latest information in their information set. As in the previous literature, the hypothesis that expectations fulfil the (orthogonality) conditions of the rational expectations hypothesis is rejected by the data. We find evidence that this is not only due to information imperfections but also to some type of misspecification of the expectations’ model that firms are using. In addition, we find some evidence that companies that have not used bank finance recently tend to do worse at forecasting its availability next period. To test how policy announcements may affect expectations, we concentrate on the possible effects of the ECB policy announcements of summer 2012, which included among other things the announcement of the European Central Bank’s Outright Monetary Transactions Program (OMT). Using a difference-in-differences approach, we find evidence of forward-looking expectations. In particular, shortly after the OMT announcement the forecast of “informed” firms were more upbeat compared to the control group of firms. This moreover was true in both vulnerable and non-vulnerable countries, suggesting that it was the relevance of the information about the future of the banking system that most mattered for expectations at the time, more than the immediate impact of the announced policy measures. JEL Classification: C83, D22, D84

On stock price overreactions: frequency, seasonality and information content

ABSTRACTThis paper explores the frequency of price overreactions in the US stock market by focusing on the Dow Jones Industrial Index over the period 1990–2017. It uses two different methods (static and dynamic) to detect overreactions and then carries out various statistical tests (both parametric and non-parametric) including correlation analysis, augmented Dickey–Fuller tests (ADF), Phillips-Perron (PP) tests, Granger causality tests, and regression analysis with dummy variables. The following hypotheses are tested: whether or not the frequency of overreactions varies over time (H1), is informative about crises (H2) and/or price movements (H3), and exhibits seasonality (H4). The null cannot be rejected except for H4, i.e., no seasonality is found. On the whole, it appears that the frequency of overreactions can provide useful information about market developments. A sharp increase in the number of overreactions occurs in crisis periods. The frequency of overreactions is linked to the VIX index and therefore could be used as an alternative measure of market sentiment and market fear, and it also affects stock returns. Further, our findings provide evidence supporting market inefficiency since price predictability can allow investors to design profitable trading strategies; in addition, the fact that the frequency of overreactions varies over time is consistent with the Adaptive Expectations Hypothesis.

Zero-coupon interest rates: Evaluating three alternative datasets

The zero-coupon yield curve is a common input for most financial purposes. We consider three popular yield curve datasets and explore the extent to which the decision as to what dataset to use for a particular application may have an impact on the results. Many term structure papers evaluate alternative models for estimating zero coupon bonds based on their ability to replicate bond prices. However, in this paper we take a step forward by analyzing the consequences of using these alternative datasets in estimates of other moments and variables such as interest rate volatilities or the resulting forward rates and their correlations. After finding significant differences, we also explore the existence of volatility spillover effects among these three datasets. Finally, we illustrate the relevance of the choice of one particular dataset by examining the differences that may arise when testing the expectations hypothesis. In the conclusions, we provide guidance to end users in selecting a particular dataset.

The term structure of systematic and idiosyncratic risk

AbstractWe study the term structure of variance (total risk), systematic, and idiosyncratic risk. Consistent with the expectations hypothesis, we find that, for the entire market, the slope of the term structure of variance is mainly informative about the path of future variance. Thus, there is little indication of a time‐varying term premium. Turning the focus to individual stocks, we cannot reject the expectations hypothesis for systematic variance, but we strongly reject it for idiosyncratic variance. Our results are robust to jumps and potential statistical biases.

Expectation hypothesis and term structure anomaly

AbstractCampbell and Shiller (1991) find the presence of term structure anomaly, in which the slope of the term structure predicts inconsistently to the change in yield of longer term bonds over the life of shorter term bonds during 1952–1987. Focusing on the post Campbell and Shiller period, our findings suggest that the anomaly is not only attributed to term premia but also relates to expectation errors. We found that macroeconomic surprises and irrationality from investors' behaviour are important determinants of time‐varying expectation errors. These factors are capable of explaining the rejection of the expectation hypothesis and the U.S. term structure anomaly in long‐term securities.

Macro Modelling at the NIESR: Its Recent History

This paper charts the evolution of mainly empirical research at the NIESR over the 1970s and 80s. As was all too evident there were very large discrete technical improvements in data handling and manipulation over this period. Less well appreciated were the effects on the economy of major supply-side shocks coming from the World economy leading to ‘Stagflation’ and, interconnected but somewhat later, in the UK, marked changes in macro policy regime. This latter was strongly influenced by the seminal papers of Lucas (1976) and Sims (1980); both highly critical of the then current practices in macroeconomics, though each having very different intellectual stances. The response in the NIESR was to engage at an early stage in these innovations; applying the mantra that an informed criticism was more efficient than an uninformed one. During this period it became a leader in the econometrics of applied macro modelling under different expectations assumptions, including the rational expectations hypothesis (REH). Throughout, it remained critical of the anti-empirical drift encouraged in the Lucas Critique, criticism borne out more recently by the financial instability of the 1990s and the crisis that followed.

Term structure dynamics at low and negative interest rates\u2014evidence from Switzerland

This paper studies the transmission of changes in short-term interest rates to longer-term government bond yields when interest rates are at very low levels or negative. We focus on Switzerland, where short-term interest rates have been at zero since late 2008 and negative since the beginning of 2015. The expectations hypothesis of the term structure implies that as nominal interest rates approach their lower bound, the effect of short-term rates on longer-term yields should decline, and positive short rate changes should have larger absolute effects than negative short rate changes. Contrary to studies of other countries, we find no evidence for a decline in the effect of short rate changes for the low-interest rate period using Swiss data. However, we do find evidence for the predicted asymmetric effect for positive and negative short rate changes during the period when short-term rates are close to zero. This asymmetry normalized again after the introduction of negative interest rates.

An Empirical Examination of Rational Expectations Hypothesis in the Foreign Exchange Market

The Efficient Market (EMH) and Rational Expectation Hypothesis (REH) have been examined for the Canadian Dollar / US Dollar and Swiss Frank / US Dollar exchange rates using data from February 1988 to May 1999 published by the Financial Times’ Currency Forecaster. Using unit root, and restricted co-integration techniques, we find that one-month ahead forecast is rational for the Swiss Frank / US Dollar exchange rate. However, one-month-ahead Canadian Dollar forecast is not rational. The study shows that when forecasting errors are corrected for serial correlation because of moving average process, three-month-ahead forecasts become rational for both the currencies. The twelve-month-ahead forecasts are not rational for any of the currencies.

Risk premia in Chinese commodity markets

This paper investigates risk premia in Chinese commodity markets by decomposing the returns of commodity futures into spot and term premia following Szymanowska et al. (2014). We find that a three-factor model that includes an equally-weighted market factor, carry and time-series momentum explains spot premia. The term premium, which represents a deviation from the expectation hypothesis, is weak. By contrast, the premium in the U.S. commodity market is significant, evidence by an average t-statistic of 4.32. This premium is explained by two investable factors that are derived using calendar spreads. We further demonstrate that the term premia are not driven by liquidity and are negatively related to basis, likely due to mean-reversion in basis.

Commentary on Retail Forecasting

This paper emphasizes that traditional tests of the EH are based on two assumptions: the expectations hypothesis (EH) per se and an assumption about the expectations generating process (EGP) for the short-term rate. Arguing that conventional tests of the EH need to assume EGPs that may be significantly at odds with the true EGP, we investigate this possibility by analyzing the out-of-sample predictive performances of several models for predicting interest rates, including a few models which assume that the EH holds in its functional form that relates long- to short-term yields. Using US riskless yield data for a 1970–2016 monthly sample and testing methods that take into account the parameter uncertainty, the null hypothesis of an equal predictive accuracy of each model relative to the random walk alternative is hardly ever rejected at intermediate and long horizons. This confirms that, at least at a practical level, the main difficulty with the EH is represented by the effective prediction of short-term rates. We discuss the relevance of these findings for central banks’ use of forward guidance.