N. Augenblick and E. Lazarus: Restrictions on Asset-Price Movements Under Rational Expectations: Theory and Evidence

August 13, 2019

How restrictive is the assumption of rational expectations in asset markets? We provide two contributions to address this question. First, we derive restrictions on the admissible variation in asset prices in a general class of rational-expectations equilibria. The challenge in this task is that asset prices reflect both beliefs and preferences. We gain traction by considering market-implied, or risk-neutral, probabilities of future outcomes, and we provide a mapping between the variation in these probabilities and the minimum curvature of utility — or, more generally, the slope of the stochastic discount factor — required to rationalize the marginal investor’s beliefs.