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IAI Actuarial Core Principles · Economic Modelling · Rational expectations theory and the efficient markets hypothesis

Which statement about the Efficient Markets Hypothesis and rational expectations is most accurate?

The EMH states that prices already reflect the relevant available information, so price changes are driven by new, unanticipated news. This links to rational expectations, where forecast errors are unpredictable. It does not imply constant prices, identical portfolios or equal returns for all investors.

  1. AEMH implies that security prices reflect available information, so price changes arise from new, unanticipated informationCorrect
  2. BEMH implies that every investor always earns the market return
  3. CEMH requires that all investors hold identical portfolios
  4. DEMH implies that prices are constant over time
  5. EMH implies that new information is reflected in prices only after several months

Explanation

Efficiency means prices quickly incorporate available information, so only unanticipated news moves them. This is consistent with rational expectations, where forecast errors are unpredictable. It does not mean prices are constant, nor that investors hold identical portfolios or earn identical returns.

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