A New Pseudo-Bayesian Model of Investors' Behavior in Financial Crises

Xu Guo, Kin Lam, Wing-Keung Wong and Lixing Zhu

MPRA Paper from University Library of Munich, Germany

Abstract: In this paper, we introduce a new pseudo-Bayesian model to incorporate the impact of a financial crisis and establish some properties of stock returns and investors' behavior during a financial crisis and subsequent recovery. Our approach provides a quantitative description for investors' representative and conservative heuristics by assuming that the earnings shock of an asset follows a modified random walk model to incorporate the impact of a financial crisis on the earnings of a firm. By using this model setup, we first establish some properties on the expected earnings shock and its volatility. Thereafter, we derive some properties of investors' behavior on the stock price and its volatility during a financial crisis and subsequent recovery. Last, we develop properties to explain some market anomalies, including short-term underreaction, long-term overreaction, and excess volatility during a financial crisis and subsequent recovery.

Keywords: Bayesian model; Representative and conservative heuristics; Underreaction; Overreaction; Stock price; Stock return; Financial crisis (search for similar items in EconPapers)
JEL-codes: C01 C11 C53 (search for similar items in EconPapers)
Date: 2012-10-31
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