Money, Banking, and Financial Markets Practice Test: The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis — Flashcards

The efficient market hypothesis (EMH) is a financial economics theory that states that asset prices reflect all available information. The EMH also states that stocks always trade at their fair value on exchanges, which means that it is impossible to outperform the market through expert stock selection or market timing. The EMH is a cornerstone of modern financial theory, but it is highly controversial and often disputed. For example, investors such as Warren Buffett have consistently beaten the market over long periods. 

The rational expectations hypothesis, also known as the efficient-markets model, is a theory that prices of securities are flexible and reflect all available information. The theory provides a market equilibrium basis for expectations based on available information. The theory emphasizes the importance of transparency, credibility, and clear communication of policy decisions to avoid unexpected effects on market behavior. 
The theory of stock market valuation states that expectations govern the valuation of stocks. Different expectations result in different expected returns and a distribution of expected capital gains. 
The EMH is the application of rational expectations to the securities market.