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How do Markets React to Fundamental Shocks? An Experimental Analysis on Underreaction and Momentum

Martin Weber and Frank Welfens ()
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Frank Welfens: Lehrstuhl für ABWL, Finanzwirtschaft, insb. Bankbetriebslehre, Postal: L 5, 2, D-68131 Mannheim

No 07-42, Sonderforschungsbereich 504 Publications from Sonderforschungsbereich 504, Universität Mannheim, Sonderforschungsbereich 504, University of Mannheim

Abstract: We perform a market experiment to investigate how average transaction prices react to the arrival of new information. Following a positive shock in fundamental value, prices underreact strongly; following negative shocks we find evidence of a much less pronounced underreaction. After the shock, prices in both situations slowly drift towards the new fundamental value, leading to a characteristic momentum pattern. Controlling for investors’ individual disposition effects we form high and low disposition markets and prove both underreaction and momentum to be stronger in the high disposition group. While evidence is mainly in favor of Grinblatt and Han (2005), we conclude based on our underreaction finding that positive and negative shocks are not two sides of the same coin and encourage future studies to disentangle the asymmetry between the two situations more carefully.

Date: 2007-06-27
Note: Financial support from the Deutsche Forschungsgemeinschaft, SFB 504, at the University of Mannheim, is gratefully acknowledged.
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