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

Pietro Veronesi

The Review of Financial Studies, 1999, vol. 12, issue 5, 975-1007

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. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Date: 1999
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