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

26 September 2012
Publication Type: Working Paper
JEL Code: C62, D81, G11, G12

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 con…firmatory 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 signi…cant attention in the behavioral …nance literature, we argue that our decision-theoretic underpinning of psychological attitudes has a less ad hoc flavor than existing approaches.

Series title: Working Paper 296
1 June 2012
Journal: Ann Finance, DOI 10.1007/s10436-012-0208-z
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