Uncertainty and the Rational Expectations Hypothesis

According to the rational expectations hypothesis, traders know the probabilities of future events, and value uncertain future payoffs by discounting their expected value at the riskless rate of interest. Under this hypothesis the best predictor of a firm's valuation in the future is its stock price today. In one famous test of this hypothesis, it was found that detailed weather forecasts could not be used to improve on contemporaneous orange prices as a predictor of future orange prices, but that orange prices could improve contemporaneous weather forecasts. Under the rational expectations hypothesis you can infer more about the odds of corporate or sovereign bonds defaulting by looking at their prices than by reading about the financial condition of their issuers.

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