Information Percolation, Momentum, and Reversal

Julien Cujean and Daniel Andrei
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Julien Cujean: Robert H. Smith School of Business
Daniel Andrei: UCLA Anderson

No 431, 2016 Meeting Papers from Society for Economic Dynamics

Abstract: We propose a rational model to explain time-series momentum. The key ingredient is word-of-mouth communication, which we introduce in a noisy rational expectations framework. Word-of-mouth communication accelerates information revelation through prices and generates short-term momentum and long-term reversal. Social interactions allow investors with heterogeneous trading strategies—contrarian and momentum traders—to coexist in the marketplace. As a result, momentum is not completely eliminated, although a significant proportion of investors trade on it. We also show that word-of-mouth communication spreads rumors and generates price run-ups and reversals. Our theoretical predictions are in line with several empirical findings.

Date: 2016
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed016:431

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