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

Marco Ottaviani, Peter Norman Sørensen

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    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.
    Original languageEnglish
    JournalAmerican Economic Review
    Volume105
    Issue number1
    Pages (from-to)1-34
    Number of pages34
    ISSN0002-8282
    DOIs
    Publication statusPublished - 2015

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