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A decision-theoretic model of asset-price underreaction and overreaction to dividend news

  • Alexander Ludwig


    (CMR, University of Cologne; Albertus-Magnus-Platz; 50923 Koln; Germany)

  • Alexander Zimper


    (Department of Economics, University of Pretoria)

We combine new developments in decision theory with a standard consumption-based asset-pricing framework. In our model the efficient market hypothesis is violated if and only if agents' beliefs express ambiguity about the stochastic process driving economic fundamentals. Asset price fluctuations result because agents with ambiguous beliefs are prone to a confirmatory bias in the interpretation of new information. We demonstrate that our approach gives rise to price-patterns of "underreaction" and "overreaction" to news about dividend payments. Although these empirical phenomena have received significant attention in the behavioral finance literature, we argue that our decision-theoretic underpinning of psychological attitudes has a less ad hoc flavor than existing approaches.

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Paper provided by University of Pretoria, Department of Economics in its series Working Papers with number 201223.

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Length: 49 pages
Date of creation: Jun 2012
Date of revision:
Handle: RePEc:pre:wpaper:201223
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