Essays on expectations and financial markets

Abstract: This thesis is a collection of three empirical papers that tests hypotheses within the context of two related and intersecting theoretical frameworks: rational expectations and efficient markets. The aim is to empirically explore to what extent households form their inflation expectations in a rational manner, and to explain why households’ perceptions may deviate from the measured official rate. This is done by studying how their expectations change with economic conditions and with information about their readiness to spend money on cars and houses. The thesis also addresses the effects of option introduction on the prices and risk of the underlying securities, where this information implicitly tests stock market efficiency.Chapter 1 provides an overview of different concepts of expectations and describes the link between the hypotheses of rational expectations and efficient markets. The chapter also presents some stylised facts about the main dataset used to explore households’ opinions about past and future inflation rates, and it provides a summary of each following chapter.Chapter 2 explores to what extent households’ inflation expectations are consistent with theories of rationality, and how these expectations change in times of major economic events and changes in the inflation environment. The events studied are the financial and economic crisis of 2008, several euro-cash changeovers, and periods of low and high inflation. The results show that households do not form rational expectations in the sense of Muth (1961).Chapter 3 investigates whether households’ purchasing plans for big expenditure items matter to households when they form their views on past and future inflation, and whether differences in their purchasing plans can explain the deviations usually found between surveyed inflation and the official measure of the rate of inflation. The results show that stronger incentives to collect information on inflation induce households to produce perceived and expected inflation rates that more closely correspond to the officially measured rate of inflation.Chapter 4 investigates the effects of option introduction on the prices and risk of the underlying securities. The results show that the introduction of options provide the underlying stocks with a significant price increase, and a persistent excess return compared to an index indicating normal return. The impact on the total risk is also favourable, while no influence on the systematic risk could be verified. Volatility in the underlying stocks decrease continuously for ten months after the introduction of the option program.