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Price Reaction to Information with Heterogeneous Beliefs and Wealth Effects: Underreaction, Momentum, and Reversal

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  • Marco Ottaviani
  • Peter Norman Sørensen

Abstract

This paper analyzes how asset prices in a binary market react to information when traders have heterogeneous prior beliefs. We show that the competitive equilibrium price underreacts to information when there is a bound to the amount of money traders are allowed to invest. Underreaction is more pronounced when prior beliefs are more heterogeneous. Even in the absence of exogenous bounds on the amount that traders can invest, prices underreact to information provided that traders become less risk averse as their wealth increases. In a dynamic setting, underreaction results in initial momentum and then reversal in the long run. (JEL D83, D84, G11, G12, G14)

Suggested Citation

  • Marco Ottaviani & Peter Norman Sørensen, 2015. "Price Reaction to Information with Heterogeneous Beliefs and Wealth Effects: Underreaction, Momentum, and Reversal," American Economic Review, American Economic Association, vol. 105(1), pages 1-34, January.
  • Handle: RePEc:aea:aecrev:v:105:y:2015:i:1:p:1-34
    Note: DOI: 10.1257/aer.20120881
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    References listed on IDEAS

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    Cited by:

    1. He, Xue-Zhong & Treich, Nicolas, 2017. "Prediction market prices under risk aversion and heterogeneous beliefs," Journal of Mathematical Economics, Elsevier, vol. 70(C), pages 105-114.
    2. Romain Gauriot Author e-mail: romain.gauriot@nyu.edu & Lionel Page Author e-mail: lionel.page@uts.edu.au, 2020. "How Market Prices React to Information: Evidence from a Natural Experiment," Working Papers 20200058, New York University Abu Dhabi, Department of Social Science, revised Oct 2020.
    3. John Fender, 2020. "Beyond the efficient markets hypothesis: Towards a new paradigm," Bulletin of Economic Research, Wiley Blackwell, vol. 72(3), pages 333-351, July.
    4. Roland Füss & Massimo Guidolin & Christian Koeppel, 2019. "Sentiment Risk Premia In The Cross-Section of Global Equity," Working Papers on Finance 1913, University of St. Gallen, School of Finance, revised May 2020.
    5. R. Jared DeLisle & H. Zafer Yüksel & Gulnara R. Zaynutdinova, 2020. "What'S In A Name? A Cautionary Tale Of Profitability Anomalies And Limits To Arbitrage," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 43(2), pages 305-344, May.
    6. de Oliveira Souza, Thiago, 2019. "Predictability concentrates in bad times. And so does disagreement," Discussion Papers of Business and Economics 8/2019, University of Southern Denmark, Department of Business and Economics.
    7. Ichkitidze, Yuri, 2018. "Temporary price trends in the stock market with rational agents," The Quarterly Review of Economics and Finance, Elsevier, vol. 68(C), pages 103-117.
    8. Remorov, Alexander, 2015. "Dynamic Trading When You May Be Wrong," MPRA Paper 63964, University Library of Munich, Germany, revised 27 Apr 2015.
    9. Marcello Pericoli & Giovanni Veronese, 2015. "Forecaster heterogeneity, surprises and financial markets," Temi di discussione (Economic working papers) 1020, Bank of Italy, Economic Research and International Relations Area.
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    11. Lionel Page & Christoph Siemroth, 2018. "How much information is incorporated in financial asset prices? Experimental Evidence," QuBE Working Papers 054, QUT Business School.
    12. Bo Cowgill & Eric Zitzewitz, 2015. "Corporate Prediction Markets: Evidence from Google, Ford, and Firm X," Review of Economic Studies, Oxford University Press, vol. 82(4), pages 1309-1341.
    13. Au, Pak Hung, 2016. "Price reaction and disagreement over public signal," Journal of Economic Behavior & Organization, Elsevier, vol. 130(C), pages 81-106.
    14. Urmee Khan, 2016. "State-dependent Preferences in Prediction Markets and Prices as Aggregate Statistic," Working Papers 201609, University of California at Riverside, Department of Economics.
    15. Roland Fuess & Massimo Guidolin & Christian Koeppel, 2019. "Sentiment Risk Premia in the Cross-Section of Global Equity and Currency Returns," BAFFI CAREFIN Working Papers 19116, BAFFI CAREFIN, Centre for Applied Research on International Markets Banking Finance and Regulation, Universita' Bocconi, Milano, Italy.
    16. Weijia Wang & Shaoan Huang, 0. "Risk sharing and financial stability: a welfare analysis," Journal of Economic Interaction and Coordination, Springer;Society for Economic Science with Heterogeneous Interacting Agents, vol. 0, pages 1-18.
    17. Giovanni Angelini & Luca De Angelis & Carl Singleton, 2019. "Informational efficiency and behaviour within in-play prediction markets," Economics Discussion Papers em-dp2019-20, Department of Economics, Reading University.

    More about this item

    JEL classification:

    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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