Essay on The Economic Rationality Assumption

Essay on The Economic Rationality Assumption

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The economic rationality assumption has given an important connation for the market efficiency, as it has been the base to carry out the construction of the modern knowledge in standard finance. Resulting in the development of the most important insights in finance, such as arbitrage pricing theory of Miller and Modigliani, the Markowitz portfolio optimization, the capital asset pricing theory of Sharp, Lintner and Sharp and the option-pricing model of Black, Scholes and Merton (Pompian, 2006 and Lo, 2005). At this stage, these advances provide a sophisticated mathematical approach to explain what happen in real life. As a result, of these advances, individuals who trade stocks and bonds use these theories under the assumption that the assets they are investing in have similar value to the prices they are paying. This way, according to the market efficiency, current prices reflect all relevant information so trading stocks in an attempt to exceed the benchmark or to produce returns above average will not be possible without taking risk above the average since with arbitrage would make go back prices to their real or fundamental value (Malkiel, 2003).
Arbitrage, could be defined as a guaranteed trading opportunity without risk to make a profit. In the case that an asset is in situation of under-valuated, will swiftly draw the attention of rational investors that would take advantage of this by buying the asset at a bargain price in large amount pushing the price to its fundamental value so the expected return is relatively higher than the risk involved (Barberis and Thaler, 2002 and Ritter, 2003). On the other hand, if an asset is over-valuated, rational investors would sell in short , in order to take advantage of the correct...

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...e intrinsic value of a portfolio of some Internet stocks was half of the market value in the late 1990’s. Therefore, if the finance analysts’ outcome were right, these huge technology companies were worth only 50 per cent of their current prices. Then this could have been prevented by institutional investors taking short position on the internet stock. But despite they did so, it had little effect, because the majority of the market participants are individual investors that are overwhelm by good moment, putting more buying pressure on this title, driving up the prices (Thaler, 1999, pp 15). Hence, this is does not make any sense according to rational equilibrium, since the US internet stock market heeded more to the peoples’ emotions rather than the fundamentals so investor are not completely rational because their behaviour also account for the market operation.

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