Stock Market Overreactions to Bad News in Good Times: A Rational Expectations Equilibrium Model

Stock Market Overreactions to Bad News in Good Times: A Rational Expectations Equilibrium Model This article presents a dynamic, rational expectations equilibrium model of asset prices where the drift of fundamentals (dividends) shifts between two unobservable states at random times. I show that in equilibrium, investors' willingness to hedge against changes in their own “uncertainty” on the true state makes stock prices overreact to bad news in good times and underreact to good news in bad times. I then show that this model is better able than conventional models with no regime shifts to explain features of stock returns, including volatility clustering, “leverage effects,” excess volatility, and time-varying expected returns. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png The Review of Financial Studies Oxford University Press

Stock Market Overreactions to Bad News in Good Times: A Rational Expectations Equilibrium Model

The Review of Financial Studies, Volume 12 (5) – Oct 1, 1999

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Publisher
Oxford University Press
Copyright
© 1999 The Society for Financial Studies
ISSN
0893-9454
eISSN
1465-7368
D.O.I.
10.1093/rfs/12.5.975
Publisher site
See Article on Publisher Site

Abstract

This article presents a dynamic, rational expectations equilibrium model of asset prices where the drift of fundamentals (dividends) shifts between two unobservable states at random times. I show that in equilibrium, investors' willingness to hedge against changes in their own “uncertainty” on the true state makes stock prices overreact to bad news in good times and underreact to good news in bad times. I then show that this model is better able than conventional models with no regime shifts to explain features of stock returns, including volatility clustering, “leverage effects,” excess volatility, and time-varying expected returns.

Journal

The Review of Financial StudiesOxford University Press

Published: Oct 1, 1999

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