How Do Investors React Under Uncertainty?
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.
|Date of creation:||01 Apr 2010|
|Date of revision:|
|Contact details of provider:|| Postal: PO Box 123, Broadway, NSW 2007, Australia|
Phone: +61 2 9514 7777
Fax: +61 2 9514 7711
Web page: http://www.uts.edu.au/research-and-teaching/our-research/paul-woolley-centre
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Larry Epstein & Martin Schneider, 2004.
"Ambiguity, Information Quality and Asset Pricing,"
RCER Working Papers
507, University of Rochester - Center for Economic Research (RCER).
- Larry G. Epstein & Martin Schneider, 2001.
RCER Working Papers
485, University of Rochester - Center for Economic Research (RCER).
- Malcolm Baker & Jeffrey Wurgler, 2007.
"Investor Sentiment in the Stock Market,"
Journal of Economic Perspectives,
American Economic Association, vol. 21(2), pages 129-152, Spring.
- 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.
- Zengjing Chen & Larry Epstein, 2002.
"Ambiguity, Risk, and Asset Returns in Continuous Time,"
Econometric Society, vol. 70(4), pages 1403-1443, July.
- 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).
- 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.
- 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.
- X. Frank Zhang, 2006. "Information Uncertainty and Stock Returns," Journal of Finance, American Finance Association, vol. 61(1), pages 105-137, 02.
- Gilboa, Itzhak & Schmeidler, David, 1989.
"Maxmin expected utility with non-unique prior,"
Journal of Mathematical Economics,
Elsevier, vol. 18(2), pages 141-153, April.
- 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.
- 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.
- J. M. Keynes, 1937. "The General Theory of Employment," The Quarterly Journal of Economics, Oxford University Press, vol. 51(2), pages 209-223.
- 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.
- 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.
- 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.
- Al-Najjar, Nabil I. & Weinstein, Jonathan, 2009. "The Ambiguity Aversion Literature: A Critical Assessment," Economics and Philosophy, Cambridge University Press, vol. 25(03), pages 249-284, November.
- 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.
- 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.
- 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.
When requesting a correction, please mention this item's handle: RePEc:uts:pwcwps:8. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Duncan Ford)
If references are entirely missing, you can add them using this form.