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# Given that the unemployment rate dropped recently to 4.0 percent, what is the adaptive expectation of inflation? What is the rational expectation of inflation? What does rational expectations theory state about forecast errors of expectations

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I need to produce something about the general theory of how capital markets work.

To explain how capital markets work, I would like to provide definitions and practical examples of the concepts of adaptive expectations, rational expectations, optimal forecast, random walk, and mean reversion.

Assumption -
The historical inflation rate has ranged between 4 percent and 6 percent, the average inflation rate has been 5 percent, and the inflation rate is 1 percent higher than the average when the unemployment rate is 4.5 percent or below.

· Given that the unemployment rate dropped recently to 4.0 percent, what is the adaptive expectation of inflation? What is the rational expectation of inflation?
· What does rational expectations theory state about forecast errors of expectations?
· How does rational expectations theory relate to efficient markets theory?
· If the current price of an asset is \$100, the cash payment to be received is \$5, and you expect the price to increase to \$103 in one year, what is the expectation of return at the beginning of this investment? How does the forecast of the future price relate to the optimal forecast in the theory of rational expectations?
· What is the "equilibrium" return of a security?
· What is the relationship between the current prices in a financial market and the security's equilibrium return?
· How does the market react to unexploited profits in an efficient market?
· If an investment adviser has performed well in the past, what does this indicate about the future?
· If stock prices follow a "random walk," what does this indicate about the predictability of future stock prices?
· What is the performance record of "technical analysts" relative to the overall market?
· What evidence exists against the theory of market efficiency with respect to the following?
1. Small-firm effect
2. January effect
3. Market overreaction
4. Excessive volatility
5. Mean reversion
· Explain why foreign exchange rates should or should not follow a random walk.

Thanks

#### Solution Preview

Hello

Please find the Powerpoint file attached. "Regular" text is below...

Thanks!

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Edition 2004, Project Management Institute, Four Square Boulevard,
Newton
Square, PATo explain how capital markets work, I would like to provide definitions and practical examples of the concepts of adaptive expectations, rational expectations, optimal forecast, random walk, and mean reversion.
The answer of Q.1 has been provided as under & also in power point file in order to give a better presentation & keeping the reasonable word limit.
Ans.1 The capital market is the market for long-term loans and equity capital. Companies and the government can raise funds for long-term investments via the capital market. The capital market includes the stock market, the bond market, and the primary market. Securities trading on organized capital markets are monitored by the government; new issues are approved by authorities of financial supervision and monitored by participating banks. Thus, organized capital markets are able to guarantee sound investment opportunities.

Expectations are formed on the basis of past experiences only, typically as some kind of weighted average of past observations.
EXAMPLE: To form a forecast for the price of IBM stock in 2005, call it Pe(2005), an investor forms a weighted average of the prices he has observed for shares of IBM in 2004, 2003, and 2002:
Pe(2005) = .70 ´ P(2004) + .20 ´ P(2003) + .10 ´ P(2002)

Theory of rational expectation
The theory of rational expectations was first proposed by John F. Muth of Indiana University in the early sixties. He used the term to describe the many economic situations in which the outcome depends partly upon what people expect to happen. The price of an agricultural commodity, for example, depends on how many acres farmers plant, which in turn depends on the price that farmers expect to realize when they harvest and sell their crops. As another example, the value of a currency and its rate of depreciation depend partly on what people expect that rate of depreciation to be. That is because people rush to desert a currency that they expect to lose value, thereby contributing to its loss in value. Similarly, the price of a stock or bond depends partly on what prospective buyers and sellers believe it will be in the future.

Random Walk Theory
The theory that stock price changes have the same distribution and are independent of each other, so the past movement or trend of a stock price or market cannot be used to predict its future movement.
In short, this is the idea that stocks take a random and unpredictable path. A follower of the random walk believes it's impossible to outperform the market without assuming additional risk. Tenets of the theory, however, recognize that stocks maintain an upward trend over time.

The rest of the items have been well explained in the ATTACHED PowerPoint presentation.

Assumption -
The historical inflation rate has ranged between 4 percent and 6 percent, the average inflation rate has been 5 percent, and the inflation rate is 1 percent higher than the average when the unemployment rate is 4.5 percent or below.