How do Markets React to Fundamental Shocks? An Experimental Analysis on Underreaction and Momentum

We perform a market experiment to investigate how average transaction prices react to the arrival of new information. Following a positive shock in fundamental value, prices underreact strongly; following negative shocks we find evidence of a much less pronounced underreaction. After the shock, prices in both situations slowly drift towards the new fundamental value, leading to a characteristic momentum pattern. Controlling for investors’ individual disposition effects we form high and low disposition markets and prove both underreaction and momentum to be stronger in the high disposition group. While evidence is mainly in favor of Grinblatt and Han (2005), we conclude based on our underreaction finding that positive and negative shocks are not two sides of the same coin and encourage future studies to disentangle the asymmetry between the two situations more carefully.

Aggregation of Information and Beliefs: Asset Pricing Lessons from Prediction Markets

In a binary prediction market in which risk-neutral traders have heterogeneous prior beliefs and are allowed to invest a limited amount of money, the static rational expectations equilibrium price is demonstrated to underreact to information. This effect is consistent with a favorite-longshot bias, and is more pronounced when prior beliefs are more heterogeneous. Relaxing the assumptions of risk neutrality and bounded budget, underreaction to information also holds in a more general asset market with heterogeneous priors, provided traders have decreasing absolute risk aversion. In a dynamic asset market, the underreaction of the first period price is followed by momentum.prediction markets; private information; heterogeneous prior beliefs; limited budget; underreaction

PENGUJIAN UNDERREACTION TERHADAP PENGUMUMAN BUYBACK DI BURSA EFEK INDONESIA

ABSTRAKTujuan penelitian ini adalah untuk melihat adanya underreaction setelahpengumuman buyback dari perusahaan di Bursa Efek Indonesia pada tahun 2013-2014. Jenis alat uji yang digunakan adalah uji t-test yaitu paired sample t-test.Sampel penelitian adalah perusahaan yang telah melakukan pengumumanbuyback di Bursa Efek Indonesia pada tahun 2013. Penelitian dibagi kedalam duatahap, yakni periode formasi portofolio dan pengujian portofolio.Hasil penelitian menunjukan bahwa telah terjadi price reversal diantaraperiode formasi dan pengujian, yaitu loser stock pada periode formasi menjadiwinner stock pada periode pengujian. Hasil ini merupakan indikator telahterjadinya underreaction di Bursa Efek Indonesia terkait saham-saham yang telahmelakukan pengumuman buyback. Dengan adanya perilaku underreaction makamenunjukkan bahwa keadaan Bursa Efek Indonesia tidak sepenuhnya efisien. Haltersebut dikarenakan masih terdapat anomaly pasar yang menyimpang dari teoripasar efisien, seperti perilaku irrasional para investor.Kata kunci: Perilaku Underreaction, Buyback, Stock Repurchase, CAR,ACAR, Portofolio, Formasi, Pengujia

Post Earnings Announcement Drift: More Risk than Investors can Bear

This paper shows how post earnings announcement drift may arise in a capital market with rational investors if the firm's earnings in consecutive periods are positively correlated and there is a fixed supply of the firm's shares.This result is driven by the fact that equilibrium share prices depend on the forward looking information contained in current earnings and the amount of risk that the fixed supply of shares imposes on the investors.If the latter is sufficiently large, share prices will be relatively rigid with respect to the forward looking information contained in current earnings.Hence, good (bad) news yields an increase (decrease) in the equilibrium price that is too small compared to the information that is released in the earnings announcement, so that positive (negative) abnormal returns are likely to occur again in the next period.earnings per share;capital markets;investment

Who Underreacts to Cash-Flow News? Evidence from Trading between Individuals and Institutions

A large body of literature suggests that firm-level stock prices 'underreact' to news about future cash flows, i.e., shocks to a firm's expected cash flows are positively correlated with shocks to expected returns on its stock. We estimate a vector autoregession to examine the joint behavior of returns, cash-flow news, and trading between individuals and institutions. Our main finding is that institutions buy shares from individuals in response to good cash-flow news, thus exploiting the underreaction phenomenon. Institutions are not simply following price momentum strategies: When price goes up in the absence of positive cash-flow news, institutions sell shares to individuals. Although institutions are trading in the 'right' direction, institutions as a group outperform individuals by only 1.44 percent per annum before transaction and other costs, because they are extremely conservative in deviating from the value-weight market index.

The Disposition Effect and Momentum

Prior experimental and empirical research documents that many investors have a lower propensity to sell those stocks on which they have a capital loss. This behavioral phenomenon, known as 'the disposition effect,' has implications for equilibrium prices. We investigate the temporal pattern of stock prices in an equilibrium that aggregates the demand functions of both rational and disposition investors. The disposition effect creates a spread between a stock's fundamental value -- the stock price that would exist in the absence of a disposition effect -- and its market price. Even when a stock's fundamental value follows a random walk, and thus is unpredictable, its equilibrium price will tend to underreact to information. Spread convergence, arising from the random evolution of fundamental values, generates predictable equilibrium prices. This convergence implies that stocks with large past price runups and stocks on which most investors experienced capital gains have higher expected returns that those that have experienced large declines and capital losses. The profitability of a momentum strategy, which makes use of this spread, depends on the path of past stock prices. Crosssectional empirical tests of the model find that stocks with large aggregate unrealized capital gains tend to have higher expected returns than stocks with large aggregate unrealized capital losses and that this capital gains 'overhang' appears to be the key variable that generates the profitability of a momentum strategy. When this capital gains variable is used as a regressor along with past returns and volume to predict future returns, the momentum effect disappears.

Commodity futures price behaviour following large one-day price changes

This study examines individual commodity futures price reactions to large one-day price changes, or “shocks”. The mean-adjusted abnormal return model suggests that investors in 6 of the 18 commodity futures examined in this study either underreact or overreact to positive surprises. It also detects underreaction patterns in 8 commodity future prices following negative surprises. However, after making appropriate systematic risk and conditional heteroskedasticity adjustments, we show that almost all commodity futures react efficiently to shocks

How markets react to earnings announcements in the absence of analysts and institutions evidence from the Saudi market

How stock markets react to news is an established area of research. We examine the behaviour of the Saudi Stock market in response to earnings announcements where there are no analysts’ forecasts, with the aim of examining the efficiency of the market. The SSM seems to underreact to positive news for the first five days and then reactions tend to strengthen in the following weeks, indicating the presence of a post–earnings announcement drift, or PEAD. At the same time, the SSM overreacts to negative news in the first five days and then reverses its direction and reports an upward post-earnings announcement drift. The individually dominated market combined with the absence of analysts’ forecasts is the main explanation for this underreaction to positive news and overreaction to negative news

Analyst Underreaction to Past Information About Earnings: reporting, processing or plain old misspecification bias?

We revisit the debate concerning the interpretation given to prior year’s earnings changes in predicting future earnings as discussed by Abarbanell & Bernard (1992), Francis & Philbrick (1993) and Easterwood and Nutt (1999). We advance a new specification of this relationship which distinguishes between earnings reversion and momentum. On a large UK dataset, we find there is substantial underreaction, particularly in situations of earnings momentum, approximately six times as large as that identified by Abarbanell & Bernard. This suggests that analysts behaviour is still a candidate to explain post earnings announcement drift. We also show that our model performs well relative to a specification recently proposed by Easterwood and Nutt (1999)