Rationality Rules

Abstract

Rationality RulesOf potential relevance to the study of extreme market events are the many models that emerged during the years of research and controversy surrounding the EMH/CAPM. These appear in the literature with colorful bubble name adjectives such as "rational," "exploding," "intrinsic," "churning," and "collapsing," though most begin with neoclassical assumptions of financial theory. 1 Substantial theoretical assumptions and econometric contortions are needed to fit "bubbles" into a conventional rational valuation-model framework. One such crucial assumption in traditional models takes the existence of arbitrage and the "law" of one price (LOOP) as a given feature. This "law"-which need not apply intertemporally and/or if buyers have less than perfect information-says that in efficient markets, all identical goods must have one price and, if not, sellers and buyers will cause convergence toward such a price. 2 It then follows that markets with arbitrage cannot be markets that are in equilibrium. But even the term "rational" is, in the context of such models, typically misspecified, misunderstood, and misapplied. 3 Muth (1961) was the first to explicitly propose a rational expectations hypothesis (REH) approach, which then gained publicity in the 1970s and 1980s as a potentially useful way to model expectations of future events. 4 Rational Expectations