What is the rational expectations hypothesis, and how is it applied to tests of hypotheses about expected returns in financial markets?
What will be an ideal response?
The rational expectations hypothesis states that we can break the realization of a return into an expected return that depends on the current information set and an unexpected component that depends only on new information and consequently does not depend in any way on the current information set. Theories of risk premiums generate hypotheses that relate unobservable expected rates of return to variables that are in the current information set. By using the rational expectations hypothesis, we can replace the expected return with the realized return minus an error term and recognize that the error term has a mean of zero and does not covary with anything in the current information set. These statistical properties allow us to test hypotheses about expected returns in financial markets.
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