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How Do Investors React Under Uncertainty?

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It has long been accepted in finance that risk plays an important role in determining valuation where risk reflects that investors are unsure as to the exact value of future returns but are able to express their prior expectations by way of a probability distribution of these returns. Knights (1921) introduced the concept of uncertainty where we possess incomplete knowledge about this distribution and so are unable to formulate priors over all possible outcomes. A number of writers (Gilboa and Schmeidler, 1989; Epstein and Schneider, 2003) have developed models that suggest that ambiguity, like risk, has a negative impact on valuation. The most common approach taken in these models is to assume that investors take a conservative approach when faced with uncertainty and base their decisions on the worst case scenario (maxmin expected utility). The area on which we concentrate in this paper is how the market faced with uncertainty reacts to the receipt of new information. The proposition being that under maxmin expected utility, the interpretation that the market will place on any information received will become more pessimistic as uncertainty increases, upgrading any bad news and downgrading any good news. Williams (2009) uses changes in the VIX (i.e. implied market volatility) as a measure of market uncertainty in his US study where he evaluates the markets response to the release of earnings news. There is a plethora of evidence dating back to Ball and Brown (1968) that confirms that the market responds positively (negatively) to good (bad) news earnings announcements. Williams finds that this response is conditioned by market uncertainty with there being the predicted asymmetric reaction to good and bad earnings news – the negative reaction to bad news increasing with uncertainty and the positive reaction to good news decreasing. In this study we use Australian data to also examine the impact of uncertainty on the market response to earnings announcements. One important difference in our findings to those of Williams is that it is not only changes in VIX but also the level of VIX that influence how the market responds to earnings information. Although generally confirming a pessimistic response by investors to earnings released at a time of high market uncertainly, we find evidence of a slight optimistic bias in the reaction of investors to earnings released at a time of low market uncertainty. We also find that the level of pessimism engendered when uncertainly is high may be significantly diluted if it occurs contemporaneously with strong market sentiment.

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Paper provided by The Paul Woolley Centre for Capital Market Dysfunctionality, University of Technology, Sydney in its series Working Paper Series with number 8.

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Length: 28 pages
Date of creation: 01 Apr 2010
Date of revision:
Handle: RePEc:uts:pwcwps:8

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  1. Larry Epstein & Martin Schneider, 2004. "Ambiguity, Information Quality and Asset Pricing," RCER Working Papers 507, University of Rochester - Center for Economic Research (RCER).
  2. Heath, Chip & Tversky, Amos, 1991. " Preference and Belief: Ambiguity and Competence in Choice under Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 4(1), pages 5-28, January.
  3. X. Frank Zhang, 2006. "Information Uncertainty and Stock Returns," Journal of Finance, American Finance Association, vol. 61(1), pages 105-137, 02.
  4. Jennifer Conrad & Bradford Cornell & Wayne R. Landsman, 2002. "When Is Bad News Really Bad News?," Journal of Finance, American Finance Association, vol. 57(6), pages 2507-2532, December.
  5. Larry G. Epstein & Martin Schneider, 2001. "Recursive Multiple-Priors," RCER Working Papers 485, University of Rochester - Center for Economic Research (RCER).
  6. Malcolm Baker & Jeffrey Wurgler, 2007. "Investor Sentiment in the Stock Market," NBER Working Papers 13189, National Bureau of Economic Research, Inc.
  7. Zengjing Chen & Larry G. Epstein, 2000. "Ambiguity, risk and asset returns in continuous time," RCER Working Papers 474, University of Rochester - Center for Economic Research (RCER).
  8. Bjørn Eraker, 2004. "Do Stock Prices and Volatility Jump? Reconciling Evidence from Spot and Option Prices," Journal of Finance, American Finance Association, vol. 59(3), pages 1367-1404, 06.
  9. Anderson, Evan W. & Ghysels, Eric & Juergens, Jennifer L., 2009. "The impact of risk and uncertainty on expected returns," Journal of Financial Economics, Elsevier, vol. 94(2), pages 233-263, November.
  10. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
  11. Kumar, Alok, 2009. "Hard-to-Value Stocks, Behavioral Biases, and Informed Trading," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 44(06), pages 1375-1401, December.
  12. Jennifer Francis & Ryan Lafond & Per Olsson & Katherine Schipper, 2007. "Information Uncertainty and Post-Earnings-Announcement-Drift," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 34(3-4), pages 403-433.
  13. Judson A. Caskey, 2009. "Information in Equity Markets with Ambiguity-Averse Investors," Review of Financial Studies, Society for Financial Studies, vol. 22(9), pages 3595-3627, September.
  14. Arzu Ozoguz, 2009. "Good Times or Bad Times? Investors' Uncertainty and Stock Returns," Review of Financial Studies, Society for Financial Studies, vol. 22(11), pages 4377-4422, November.
  15. Dow, James & Werlang, Sergio Ribeiro da Costa, 1992. "Uncertainty Aversion, Risk Aversion, and the Optimal Choice of Portfolio," Econometrica, Econometric Society, vol. 60(1), pages 197-204, January.
  16. Alon Brav & J.B. Heaton, 2002. "Competing Theories of Financial Anomalies," Review of Financial Studies, Society for Financial Studies, vol. 15(2), pages 575-606, March.
  17. Matthias Gysler & Jamie Kruse & Renate Schubert, 2002. "Ambiguity and Gender Differences in Financial Decision Making: An Experimental Examination of Competence and Confidence Effects," CER-ETH Economics working paper series 02/23, CER-ETH - Center of Economic Research (CER-ETH) at ETH Zurich.
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Cited by:
  1. Kang, Wensheng & Ratti, Ronald A., 2013. "Oil shocks, policy uncertainty and stock market return," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 26(C), pages 305-318.
  2. Ron Bird & Daniel Choi & Danny Yeung, 2014. "Market uncertainty, market sentiment, and the post-earnings announcement drift," Review of Quantitative Finance and Accounting, Springer, vol. 43(1), pages 45-73, July.
  3. Dutt, Tanuj & Humphery-Jenner, Mark, 2013. "Stock return volatility, operating performance and stock returns: International evidence on drivers of the ‘low volatility’ anomaly," Journal of Banking & Finance, Elsevier, vol. 37(3), pages 999-1017.
  4. Kiran Thapa, 2013. "Stock Message Board Recommendations and Share Trading Activity," PhD Thesis, Finance Discipline Group, UTS Business School, University of Technology, Sydney, number 10.
  5. Ron Bird & Daniel Choi & Danny Yeung, 2011. "Market Uncertainty and Sentiment, and the Post-Earnings Announcement Drift," Working Paper Series 15, The Paul Woolley Centre for Capital Market Dysfunctionality, University of Technology, Sydney.

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