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Overreaction of index futures in Hong Kong
Abstract
In this paper we show that the pricing error of index futures relative to its fair value can be used to identify investors' overreaction in index futures market. Specifically, when investors are overly pessimistic (optimistic), the prices of index futures are well below (above) their fair values. When the excess pessimism (optimism) is gone, the prices of index futures revert to catch up with their fair values. After taking into consideration transaction cost, execution time lag, and risk adjustment, profitable strategies can be developed to exploit this overreaction. We find that overreaction exists during intraday trading and market closing.
... To the best of our knowledge, only few previous studies have considered intraday data while investigating the overreaction hypothesis (e.g. Fung and Lam, 2004;Levy and Lieberman, 2013;Miwa, 2019;Borgards and Czudaj, 2020) and no study has considered commodity markets. ...
... They observe that there is price overreaction in US market returns when foreign markets are closed. Fung and Lam (2004) find that overreaction also exists during intraday trading and market closing. ...
In this note, we examine whether the volatility predictive power of investor sentiment for currencies and commodities is sensitive to the COVID-19 pandemic. The Credit Suisse Fear Barometer (CSFB) and the VIX are used to measure investor sentiment. The volatility of seven major currencies, gold, and oil is investigated. Using daily data from 2005 to 2020, we show that VIX is a better predictor than CSFB. However, they have no predictive power during the COVID-19 pandemic period. This may be attributed to the different nature of fear sentiment during the crisis.
... To the best of our knowledge, only few previous studies have considered intraday data while investigating the overreaction hypothesis (e.g. Fung and Lam, 2004;Levy and Lieberman, 2013;Miwa, 2019;Borgards and Czudaj, 2020) and no study has considered commodity markets. ...
... They observe that there is price overreaction in US market returns when foreign markets are closed. Fung and Lam (2004) find that overreaction also exists during intraday trading and market closing. ...
The objective of this paper is to examine the overreaction behavior of 20 commodity futures based on intraday data from November 20, 2019 to June 3, 2020 with a focus on the impact of the Covid-19 pandemic. A dynamic and non-parametric approach is applied on intraday data for four different frequencies (from 1 min to 1 h) and two different sub-periods (pre-Covid-19 pandemic and during Covid-19 pandemic) in order to detect overreaction behavior which is defined as a large change of prices followed by proportional price reversals. Our empirical findings show that the overreaction hypothesis is confirmed for the considered commodity futures. Furthermore, both the number and the amplitude of overreactions is higher during the Covid-19 pandemic. Our findings also indicate that soft and metal commodities show much less overreactions than precious metals and especially energy commodities. In particular, crude oil futures exhibit a different overreaction behavior compared to other commodities since it has a higher number of negative than positive overreactions during the Covid-19 pandemic. We also find that the data frequency is independent of the overreacting behavior in both periods as the results continuously improve when having more observations due to higher frequencies. Finally, we find that extreme overreactions during the Covid-19 pandemic provide a great potential for profitable trading returns, which can be exploited by traders.
... more pronounced for winners rather than losers. They noted that there was a delay in price reversal and argue that cultural factors may account for the small size of the price reversal as well as the delay or lack of reversal. Leung and Li (1998) mentioned that prior losers outperform prior winners during the subsequent test in the reversal period. Fung and Lam (2004) showed that loser portfolios of the 33 stocks in the Hang Seng Index, on average, outperform the winner portfolios by 9.9% one year after the formation periods and once more the study was using the De Bondt and Thaler (1985) approach. However this study was limited to 33 stocks and fails to consider that a substantial amount of companie ...
... Leung and Li (1998) mentioned that prior losers outperform prior winners during the subsequent test in the reversal period. Fung and Lam (2004) showed that loser portfolios of the 33 stocks in the Hang Seng Index, on average, outperform the winner portfolios by 9.9% one year after the formation periods and once more the study was using the De Bondt and Thaler (1985) approach. However this study was limited to 33 stocks and fails to consider that a substantial amount of companies in Hong Kong are listed in other countries. ...
We investigate the profitability of contrarian investment strategies for equities listed on the Hong Kong Stock Exchange (HKEX), which are separated into cross-listed firms and firms listed only in Hong Kong. We also investigate the relationship between stock returns and past trading volume for these equities. We report significantly higher contrarian profits for the period investigated and find that this is a persistent feature of stock returns for cross-listed companies. We also document that contrarian portfolios earn returns as high as 8.01% per month for the dually-traded companies and just 1.83% for only HKEX-listed firms. We find that volume has only a limited ability to explain contrarian profits. All extreme profits disappeared after adjusting for the Fama and French three-factor model.
... 1 1 Although the term " overreaction " has been normally associated with long horizon investments, where " short-run " refers to a period of weeks or even months (see for example Jegadeesh and Titman, 1995); several papers, among which stands out Ederington and Lee (1993, 1995), provide empirical evidence that high frequency returns may also overreact to news events. Accordingly the " intraday overreaction hypothesis " has been already empirically tested (see, for example, Fung and Lam, 2004, and Grant et al., 2005). ...
... 1 1 Although the term " overreaction " has been normally associated with long horizon investments, where " short-run " refers to a period of weeks or even months (see for example Jegadeesh and Titman, 1995); several papers, among which stands out Lee (1993, 1995), provide empirical evidence that high frequency returns may also overreact to news events. Accordingly the " intraday overreaction hypothesis " has been already empirically tested (see, for example, Lam, 2004, and Grant et al., 2005). Since the work of Bondt and Thaler (1985), overshooting effects have been commonly explained by cognitive misperceptions of market participants. ...
This paper examines the partial adjustment factors of FTSE 100 stock index and stock index futures. Using high frequency data since January 15, 1997 until March 17, 2000, it aims to assess the informational impact of the new electronic trading systems recently implemented at London Stock Exchange and LIFFE. The results suggest that information runs mainly from the futures market to the spot market. We find that the introduction of SETS, in October 1997, has increased the FTSE 100 index absolute efficiency; however it reduced the informational feedback to the futures market. The implementation of LIFFE CONNECT at LIFFE, in May 1999, has reduced the absolute and relative efficiency of FTSE 100 futures. These findings seem to imply that during the period under scrutiny electronic trading has increased the level of microstructural noise, probably due to the bid-ask bounce and order flow imbalances.
... As discussed in Daniel et al. (1998) overreaction can arise from biased behavior. One of the behaviors that cause overreaction in financial markets stems from the tendency of people to make predictions using what is known as representativeness rather than Bayes' rule (Fung & Lam, 2004). An important symptom of the representativeness heuristic, discussed in detail by Tversky and Kahneman, is that individuals think they see patterns in truly random sequences (Barberies et al., 2005). ...
... Fung, Mok, and Lam (2000) find support favouring the overreaction hypothesis for the S&P 500 and the Hang Seng Index Futures. Fung and Lam (2004) show that the pricing error can serve as a proxy for investor sentiment. Wang (2001) uses the total open interest to compute the sentiment index, while the net trading positions are used by Wang (2003) and Wang (2004). ...
The paper attempts to capture the sentiment derived from routine financial news and outlines the impact of the media content on the main index futures contracts of Hong Kong and Singapore. News factors are generated from routine financial news, but pessimistic market sentiment factors are more prevalent. High pessimistic news factors predict lower returns for the same day, and the returns start to reverse two days after the news for Hong Kong and Singapore markets. The finding is consistent with the sentiment theory. There is a significant reversal in returns, and the reversal in returns offsets the initial changes entirely. The bad news factor does not seem to work as a proxy for trading costs. The sub-sample results are similar to the whole sample. We also find the significant impact of U.S. news sentiment on news factors, futures return, and open interests in both markets. Trading strategies based on bad news factors generate economically significant returns when trading costs are considered.
... We find that the eight three-day candlestick reversal patterns can create value for investors, which agrees with the use of a number of contrarian strategies (De Bondt and Thaler, 1985;Lo and Mackinlay, 1990;Jegadeesh and Titman, 1995) in behavioral finance. Fung and Lam (2004) argue that price reversals are due to the overreactions of investors. Similarly, Bloomfield and Hales (2002) claim that investors overreact more to trends that have previously occurred, which echoes the results found in this study. ...
... The overreaction is studied in the spot market, when the optimism of the investor is removed; the prices come back to its reasonable value. Fung and Lam (2004) A. Salm and Schuppli (2010) examined that the future trading can be the best option for the investor to hedge their risk of the spot market, the noise from the future index might destabilize the spot market. Chau et al. (2011) study examines that the feedback of the positive sentiments created by trading of the past returns of the investors, if investors have positive returns then the behavior of the investors are optimistic. ...
JEL Classification: D 920, E 220, F 210 Purpose: This study bridges the gap between future trading prospects and information required to mold investors' sentiments so s/he could devise better future trading strategies. Methodology/Sampling: This study takes all companies which trade the futures on the KSE. This study used the monthly data of the futures trading, stock return, stock turnover, high-low ratio and the realized volatility. The data is taken from January 2008 to December 2012 to test investor sentiments impact on future trading. Companies' data is retrieved from the official website of KSE. The thirty-eight companies' data is used in this study. Findings: The contrivance of future trading relationship with the investor sentiments is appraised in this study. The main difference between this and the previous discourse is that we construct the futures trading model that employ the investor sentiments.
... The reversal patterns agree with the view of Bloomfield and Hales (2002) that investors overreact more to trends that have previously occurred. Fung and Lam (2004) and Fung et al. (2010) also pointed out that price reversals are due to investor overreactions. In practice, the continuation pattern (2pc in downtrends) may be applicable to momentum strategies (Bloomfield et al., 2009), while the reversal patterns are suitable for contrarian ones (De Bondt and Thaler, 1985;Lo and Mackinlay, 1990;Jegadeesh and Titman, 1995;Chou et al., 2007). ...
... 9 See e.g. Baker and Wurgler (2006), Cliff (2004, 2005), Coakley and Fuertes (2006), and Fung and Lam (2004). 10 The finding, that institutional investors often behave more sophisticated than individuals, has been shown in several studies (see e.g. ...
How is it possible that exchange rates move in the long run towards fundamentals, while professionals form consistently irrational exchange rate expectations? We look at this puzzle from a different perspective by analyzing investor sentiment in the US-dollar market. First, long-horizon regressions show that investor sentiment is connected with exchange rate returns at longer horizons, i.e. more than two years. Second, sentiment is cointegrated with fundamentals, whereas third, this relation becomes stronger, the larger exchange rate's misalignment from long-run PPP. In sum, investor sentiment's behavior in the US-dollar market closely matches with established facts of empirical exchange rate research.
... Papers relevant to the intraday case are Fabozzi, Ma, Chittenden and Pace (1995), Fung, Mok and Lam (2000), Fung and Lam (2004), Grant, Wolf and Yu (2005) and Kang (2005). The first four of these papers deal with the intraday contrarian or price reversal effect only and use approaches rather different from the winner/loser ranking method used here. ...
We study ultra short term return predictability based on intraday momentum and contrarian effects on the JSE. Statistically significant return predictability is found to be present to some extent when returns are calculated from mid-quote prices. However, when returns are calculated under bid-ask pricing assumptions which are more realistic from a trading point of view, intraday momentum and contrarian effects largely disappear and cannot be exploited profitably.
We examine how investor sentiment influences KOSPI 200 futures mispricing under varying market conditions, including volatility, short‐sale restrictions, and regulatory changes. The sentiment–mispricing relationship intensifies during high volatility, as arbitrageurs face greater constraints in correcting price distortions, leading to increased mispricing. Short‐sale restrictions further amplify mispricing and the impact of pessimistic sentiment. Regulatory reforms reducing domestic trading activity also shape sentiment–mispricing dynamics, suggesting that lower participation by irrational investors enhances market efficiency. Our findings underscore the importance of market‐specific factors—arbitrage constraints and regulations—in understanding sentiment‐driven mispricing.
This study investigates the characteristics of traders' overreaction behaviour in China's soybean and corn futures markets to the overnight performance of U.S. futures markets and examines the impacts of the night trading policy on such overreaction behaviour. Our results reveal that traders in China generally overreact to U.S. markets' performance, but the overreaction diminishes when traders have enough time to calm their emotions. We also find that the introduction of night trading implemented by China's futures exchanges significantly reduces daytime overreaction because the extension of trading hours ensures that unexpected information is promptly reflected during night trading sessions. The proposed trading strategy of exploiting the overreaction generates considerable profits. However, it has not worked since the introduction of night trading, which further confirms the policy effect of night trading. Our study provides valuable guidance for futures exchanges seeking to monitor overreaction behaviour and formulate policies to target such behaviour.
This research, which takes stock market index data as input in contrast to De Bondt and Thaler’s (1985) classical approach for testing overreaction hypothesis on a micro scale via individual stocks, is aimed at analyzing reactions of the market in aggregate and portfolio groups, which are represented by indexes. The shock-filtering procedure is based on 50-day window, encompassing observations from 60 days to 11 days prior to an observation as suggested by
Lasfer et al. (2003) while volatility has been estimated through Exponentially Weighted Moving Average (EWMA) method. Indexes resembling each other and significantly differing from others in terms of their reaction on the day of shocks, which are detected by a different threshold have been determined. The analysis implemented separately for two sub-periods outputs findings which support the validity of underreaction on all indexes except XUSIN within 2000-2008, in line with the reference researches on indexes. This result is, however valid only for positive shocks. The cautious behavior against good news disappears in the second sub-period (2009-2018). This variation can be regarded as a sign of our market’s progress in terms of information efficiency. Putting forth no significant over or underreaction of indexes to shocks, this paper shows results in compatible with the Efficient Market Hypothesis (EMH) which asserts just and timely reactions to shocks.
On the basis of the theory developed by Daniel, Hirshleifer, and Subrahmanyam (DHS) (1998), this study examines the influence of information disclosure rating on continuing overreaction and the role and effects of information disclosure rating in emerging markets. Using a comprehensive sample of firms listed in the Shenzhen Stock Exchange (hereafter, SZSE) from 2001 to 2018, this study finds that a higher information disclosure rating leads to greater continuing overreaction and that increased investor attention, rather than stock liquidity, is the main channel of influence. According to a review of relevant literature, this is the first study to evaluate the association between information disclosure rating and continuing overreaction. After the addition of control variables, use of alternative proxies, and overcoming potential endogeneity problems, a robust conclusion is obtained. Moreover, considering the uniqueness of China’s stock market, tests of the split-share structure reform (SSSR) and state-owned enterprises are conducted. Compared with those of developed countries, China’s information disclosure system is not mature and comprehensive. Therefore, financially illiterate individual investors, when exposed to large amounts of information, are unable to make rational decisions and tend to rely too much on official sources and follow the herd, leading to a more serious continuing overreaction in the market.
Extant behavioural finance theories employ cross-section of company-specific data to examine investor sentiment, which enabled these theories to only link investor sentiment with corporate stock price. However, similar to economic psychology, this study proposes that sentiment is a force that combines investors' opinion and their experience with market that requires a combination of attitude, market and macroeconomic information to link investor sentiment with financial performance. By constructing the first investor sentiment index for Malaysia; this study investigates long-and short-run relationship between investor sentiment and indicators of financial performance in Malaysia. The study employs factor analysis to construct investor sentiment index. Vector Error Correction Model is utilised to investigate short-and long-run relationships between time series of investor sentiment index and stock price (composite and for various sectors), currency exchange rate index, bank deposit and foreign direct investment. The study utilises data range of 56 quarters between the year 1998 and 2011. Investor sentiment, alone as well as with other determinants, was found to be a significant predictor of contemporaneous stock price, currency exchange rate, bank deposit and foreign direct investment. Strong wave of investor sentiment in the long-run repulses investors from the financial market due to declining investor confidence. Partially significant short-run relationship and irregular error correction possibility signify that sentiment-biased investors underperform rational investors. Manufacturing sector is more exposed to investor sentiment than stocks of other sectors. Similar to stock market, results indicate that higher sentiment brings local and foreign investors to financial markets when the bank deposit and foreign direct investment connect positively to higher investor sentiment. Sentiment in conjunction with gross domestic products, interest rate and money supply negatively influence currency rate. The study finds that overconfidence of Malaysian investors is stronger than their herding behaviour or market sentiment. It can also be inferred from the results that retail investor sentiment is stronger than the institutional investor sentiment in Malaysia.
Using intraday trading data during the 2008 financial crisis, from the Standard and Poor’s Depository Receipt (SPDR) market, we test for evidence of the informational advantage of traders. In addition, we examine the effect of pricing error on trade price. If traders are rational, and have accurate information, they will only purchase an asset at a premium (discount) if they have reason to believe that the fundamental value of that asset will increase (decrease). Our results show that the trading price of the SPDR does not significantly predict the movement of underlying asset values. This finding is consistent with traders overreacting to disparities between price and underlying value during the financial crisis.
Abstract
A number of empirical studies have focused on examining the stock index futures arbitrage. The reported results were not consistent and depended on a number of factors. Our study aims to review the literature on stock index futures arbitrage using meta-regression techniques. In particular, it aims to synthesize estimates on the existence of mispricing and on the relationship between mispricing and time to maturity. We do not find strong evidence on the publication bias in reported estimates on mispricing and estimates on the effect of time to maturity on mispricing. Finally, this study tests whether characteristics of data and publication determine the heterogeneity in the reported estimates on mispricing and time to maturity. The results suggest that these characteristics could explain these differences significantly.
We set out in this study to conduct a comprehensive analysis of the profitability of every possible 1-day candlestick pattern using data on the 30 component stocks of the Dow Jones Industrial Average index. Our study involves a very lengthy sample period running from January 1974 to December 2009, with the results revealing a noticeable increase in the predictive power of 1-day candlestick patterns from 1992 onwards. Our evidence shows that several of the patterns may well prove to be profitable for the Dow Jones Industrial Average stocks. The robustness of our results is subsequently confirmed based upon a bootstrap analysis.
This study examines individual commodity futures price reactions to large one-day price changes, or ‘shocks’. The mean-adjusted abnormal return model suggests that investors in 6 of the 18 commodity futures examined in this study either underreact or overreact to positive surprises. It also detects underreaction patterns in eight commodity future prices following negative surprises. However, after making appropriate systematic risk and conditional heteroscedasticity adjustments, we show that almost all commodity futures react efficiently to shocks.
Purpose
The purpose of this paper is to examine the risk of inefficiency of China's stock index futures market by investigating the opportunity and profitability of exchange‐traded fund (ETF) arbitrage. The explanation of behavioral risk to market efficiency is examined.
Design/methodology/approach
Based on cost‐of‐carry model, some assumptions about market efficiency were examined, and statistical tests were implemented to support the findings.
Findings
In China, borrowing and lending interest rates are quite different; dividends are small and paid in an irregular manner; and short sale cannot be used in arbitrage by all investors. It is found that the Chinese index futures market is far from efficient.
Originality/value
With reference to the empirical study, this is believed to be the first application of behavioral study to the study of market efficiency. The analysis of the statistics about Chinese index futures market and the algorithm parameters are very valuable for in‐depth understanding of the emerging markets.
This paper assesses the intraday price reversal patterns of seven major currency futures contracts traded on the Chicago Mercantile Exchange over 1988-2003 after one-day returns and opening gaps. We observe significant intraday price reversal patterns in five of the seven currency futures contracts, following large price changes. We conduct additional tests in three sub-periods (1988-1992, 1993-1998 and 1999-2003) to examine the impact of the introduction of electronic trading on GLOBEX in 1992 (to assess how a near 24-hour trading session might impact the next day opening and closing futures prices) and the introduction of the Euro in 1999 (to assess its impact on price predictability in other futures markets). We find that the introduction of the GLOBEX in 1992 significantly reduced pricing errors in currency futures in the second sub-period making the currency futures markets fairly efficient. However, the introduction of the new currency, the Euro, and the disappearance of several European currencies in 1999, resulted in significant price patterns (mostly reversals and some persistence) in most of the currency futures, indicating inefficiencies in the third sub-period.
We extend the overreaction study to interaction of international markets and find that intraday price reversals exist in Asian index futures markets following extreme movement in U.S. market. Profitable opportunities exist after considering transaction cost. We show that the reversal cannot be explained by rational arguments such as risk, liquidity and bid-ask spread. We further observe that a magnitude effect exists. Overreaction is more prominent in the latter period than in the initial period. After calm-down periods, overreaction is greatly reduced. These observations support the explanation that the source of price reversals lies in behavioral biases.
This paper examines the effect of the past price information on the two major futures contracts traded on the Tokyo Stock Exchange: the TOPIX futures and the 10-year JGB futures. The unique 90-minute lunch break on the exchange creates two mini-sessions in each calendar-trading day. This paper compares these contracts between the morning and afternoon sessions. In addition, percentage-returns and tick-size-returns are used to measure the intraday price movements following past price performance. These futures contracts present evidence of short-term market inefficiency over the period 1994 to 2003.
"Nowhere does history indulge in repetitions so often or so uniformly as in Wall Street," observed legendary speculator Jesse Livermore. History tells us that periods of major technological innovation are typically accompanied by speculative bubbles as economic agents overreact to genuine advancements in productivity. Excessive run-ups in asset prices can have important consequences for the economy as firms and investors respond to the price signals, resulting in capital misallocation. On the one hand, speculation can magnify the volatility of economic and financial variables, thus harming the welfare of those who are averse to uncertainty and fluctuations. But on the other hand, speculation can increase investment in risky ventures, thus yielding benefits to a society that suffers from an underinvestment problem.
Many decisions are based on beliefs concerning the likelihood of uncertain events such as the outcome of an election, the guilt of a defendant, or the future value of the dollar. Occasionally, beliefs concerning uncertain events are expressed in numerical form as odds or subjective probabilities. In general, the heuristics are quite useful, but sometimes they lead to severe and systematic errors. The subjective assessment of probability resembles the subjective assessment of physical quantities such as distance or size. These judgments are all based on data of limited validity, which are processed according to heuristic rules. However, the reliance on this rule leads to systematic errors in the estimation of distance. This chapter describes three heuristics that are employed in making judgments under uncertainty. The first is representativeness, which is usually employed when people are asked to judge the probability that an object or event belongs to a class or event. The second is the availability of instances or scenarios, which is often employed when people are asked to assess the frequency of a class or the plausibility of a particular development, and the third is adjustment from an anchor, which is usually employed in numerical prediction when a relevant value is available.
We compare two competing theories of financial anomalies: “behavioral” theories built on investor irrationality, and “rational
structural uncertainty” theories built on incomplete information about the structure of the economic environment. We find
that although the theories relax opposite assumptions of the rational expectations ideal, their mathematical and predictive
similarities make them difficult to distinguish. Even if irrationality generates financial anomalies, their disappearance
still may hinge on rational learning—that is, on the ability of rational arbitrageurs and their investors to reject competing rational explanations for
observed price patterns.
ABSTRACT Two easily measured variables, size and book-to-market equity, combine to capture the cross-sectional variation in average stock returns associated with market {3, size, leverage, book-to-market equity, and earnings-price ratios. Moreover, when the tests allow for variation in {3 that is unrelated to size, the relation between market {3 and average return is flat, even when {3 is the only explanatory variable. THE ASSET-PRICING MODEL OF Sharpe (1964), Lintner (1965), and Black (1972)
This chapter provides a selective review of recent work in behavioral finance. Modern finance assumes that the study of substantively rational solutions to normative problems forms an adequate basis for understanding actual behavior. Substituting mathematical logic for empirical observation is regarded as convenient. To make scientific progress, some diversity in methods is probably a good thing. In particular, much is gained—and, possibly, some anomalies could be resolved—by careful observation of what people actually do. General behavioral principles are explored that apply in multiple economic contexts—for example, excessive self-confidence. Some principles are suggested and confirmed by psychological experiments. A systematic review of evidence that behavioral factors matter outside the laboratory, that is, even when a lot of money is at stake, is presented in the chapter. A pragmatic empirical work is presented to collect a set of robust empirical facts that stand out. The chapter discusses financial innovation during the last few decades. Three driving forces are suggested for this (1) the demand for completing the market, (2) the lowering of transactions costs, and (3) reductions in agency and monitoring costs. The innovation is interpreted as a response to regulatory changes. These forces, while relevant, leave out the central question of the design and the marketing of financial products.
We observe intraday price reversals following large price changes at the opening of the S&P 500 Futures market and the HSI Futures market. We note that the magnitude of subsequent price reversals is positively related to the initial price changes, and that the price reversals are not caused by a bid–ask spread, or by panic among investors. We also note that such price reversals can be exploited to give rise to profitable opportunities after transaction costs, even though these may not be very significant. This study shows that investor overreaction may be a universal phenomenon and irrational investor behavior like overreaction may also exist among groups of sophisticated investors.
This article described three heuristics that are employed in making judgements under uncertainty: (i) representativeness, which is usually employed when people are asked to judge the probability that an object or event A belongs to class or process B; (ii) availability of instances or scenarios, which is often employed when people are asked to assess the frequency of a class or the plausibility of a particular development; and (iii) adjustment from an anchor, which is usually employed in numerical prediction when a relevant value is available. These heuristics are highly economical and usually effective, but they lead to systematic and predictable errors. A better understanding of these heuristics and of the biases to which they lead could improve judgements and decisions in situations of uncertainty.
This article described three heuristics that are employed in making judgements under uncertainty: (i) representativeness,
which is usually employed when people are asked to judge the probability that an object or event A belongs to class or process
B; (ii) availability of instances or scenarios, which is often employed when people are asked to assess the frequency of a
class or the plausibility of a particular development; and (iii) adjustment from an anchor, which is usually employed in numerical
prediction when a relevant value is available. These heuristics are highly economical and usually effective, but they lead
to systematic and predictable errors. A better understanding of these heuristics and of the biases to which they lead could
improve judgements and decisions in situations of uncertainty.
Typescript (photocopy) Thesis (Ph. D.)--Cornell University, Jan., 1985. Bibliography: leaves 120-128.
We compare two competing theories of financial anomalies: "behavioral" theories built on investor irrationality, and "rational structural uncertainty" theories built on incomplete information about the structure of the economic environment. We find that although the theories relax opposite assumptions of the rational expectations ideal, their mathematical and predictive similarities make them difficult to distinguish. Even if irrationality generates financial anomalies, their disappearance still may hinge on rational learning--that is, on the ability of rational arbitrageurs and their investors to reject competing rational explanations for observed price patterns. Copyright 2002, Oxford University Press.
Corruption in the public sector erodes tax compliance and leads to higher tax evasion. Moreover, corrupt public officials abuse their public power to extort bribes from the private agents. In both types of interaction with the public sector, the private agents are bound to face uncertainty with respect to their disposable incomes. To analyse effects of this uncertainty, a stochastic dynamic growth model with the public sector is examined. It is shown that deterministic excessive red tape and corruption deteriorate the growth potential through income redistribution and public sector inefficiencies. Most importantly, it is demonstrated that the increase in corruption via higher uncertainty exerts adverse effects on capital accumulation, thus leading to lower growth rates.
Recent empirical research in finance has uncovered two families of pervasive regularities: underreaction of stock prices to news such as earnings announcements, and overreaction of stock prices to a series of good or bad news. In this paper, we present a parsimonious model of investor sentiment, or of how investors form beliefs, which is consistent with the empirical findings. The model is based on psychological evidence and produces both underreaction and overreaction for a wide range of parameter values.
The basic paradigm of asset pricing is in vibrant flux. The purely rational approach is being subsumed by a broader approach based upon the psychology of investors. In this approach, security expected returns are determined by both "risk" and "misvaluation". This survey sketches a framework for understanding decision biases, evaluates the a priori arguments and the capital market evidence bearing on the importance of investor psychology for security prices, and reviews recent models. Copyright The American Finance Association 2001.
Firm sizes and book-to-market ratios are both highly correlated with the average returns of common stocks. Eugene F. Fama and Kenneth R. French (1993) argue that the association between these characteristics and returns arise because the characteristics are proxies for nondiversifiable factor risk. In contrast, the evidence in this article indicates that the return premia on small capitalization and high book-to-market stocks does not arise because of the comovements of these stocks with pervasive factors. It is the characteristics rather than the covariance structure of returns that appear to explain the cross-sectional variation in stock returns. Copyright 1997 by American Finance Association.
In a previous paper, we found systematic price reversals for stocks that experience extreme long‐term gains or losses: Past losers significantly outperform past winners. We interpreted this finding as consistent with the behavioral hypothesis of investor overreaction. In this follow‐up paper, additional evidence is reported that supports the overreaction hypothesis and that is inconsistent with two alternative hypotheses based on firm size and differences in risk, as measured by CAPM‐betas. The seasonal pattern of returns is also examined. Excess returns in January are related to both short‐term and long‐term past performance, as well as to the previous year market return.
Two easily measured variables, size and book-to-market equity, combine to capture the cross-sectional variation in average stock returns associated with market "beta", size, leverage, book-to-market equity, and earnings-price ratios. Moreover, when the tests allow for variation in "beta" that is unrelated to size, t he relation between market "beta" and average return is flat, even when "beta" is the only explanatory variable. Copyright 1992 by American Finance Association.
Changes in variance, or volatility, over time can be modeled using the approach based on autoregressive conditional heteroscedasticity. Another approach is to model variance as an unobserved stochastic process. Although it is not easy to obtain the exact likelihood function for such stochastic variance models, they tie in closely with developments in finance theory and have certain statistical attractions. This article sets up a multivariate model, discusses its statistical treatment, and shows how it can be modified to capture common movements in volatility in a very natural way. The model is then fitted to daily observations on exchange rates.
The primary aim of the paper is to place current methodological discussions in macroeconometric modeling contrasting the ‘theory first’ versus the ‘data first’ perspectives in the context of a broader methodological framework with a view to constructively appraise them. In particular, the paper focuses on Colander’s argument in his paper “Economists, Incentives, Judgement, and the European CVAR Approach to Macroeconometrics” contrasting two different perspectives in Europe and the US that are currently dominating empirical macroeconometric modeling and delves deeper into their methodological/philosophical underpinnings. It is argued that the key to establishing a constructive dialogue between them is provided by a better understanding of the role of data in modern statistical inference, and how that relates to the centuries old issue of the realisticness of economic theories.
Faculty of Business, McMaster University. The author is indebted to Professors Harold Bierman, Jr., Thomas R. Dyckman, Roland E. Dukes, Seymour Smidt, Bernell K. Stone, all of Cornell University, and particularly to this Journal's referees, Nancy L. Jacob and Marshall E. Blume, for their very helpful comments and suggestions. Of course, any remaining errors are the author's responsibility. Research support from the Graduate School of Business and Public Administration, Cornell University is gratefully acknowledged.
: We model a market populated by two groups of boundedly rational agents: "newswatchers" and "momentum traders". Each newswatcher observes some private information, but fails to extract other newswatchers' information from prices. If information diffuses gradually across the population, prices underreact in the short run. The underreaction means that the momentum traders can profit by trend-chasing. However, if they can only implement simple (i.e., univariate) strategies, their attempts at arbitrage must inevitably lead to overreaction at long horizons. In addition to providing a unified account of under- and overreactions, the model generates several other distinctive implications. * Stanford Business School and MIT Sloan School of Management and NBER. This research is supported by the National Science Foundation and the Finance Research Center at MIT. We are grateful to Denis Gromb, Ren Stulz, an anonymous referee, and seminar participants at MIT, Michigan, Wharton, Duke, UCLA, Berk...
We examine how the evidence of predictabilityinasset returns a#ects optimal portfolio choice for investors with long horizons. Particular attention is paid to estimation risk, or uncertainty about the true values of model parameters. We #nd that even after incorporating parameter uncertainty, there is enough predictability in returns to make investors allocate substantially more to stocks, the longer their horizon. Moreover, the weak statistical signi#cance of the evidence for predictability makes it important to take estimation risk into account; a long-horizon investor who ignores it mayover-allocate to stocks by a sizeable amount. # Graduate School of Business, University of Chicago. I am indebted to John Campbell and Gary Chamberlain for guidance and encouragement. I also thank an anonymous referee, the editor Ren#e Stulz, and seminar participants at Harvard, the Wharton School, Chicago Business School, the Sloan School at MIT, UCLA, Rochester, NYU, Columbia, Stanford, IN...
Investment performance of common stocks in relation to their price-earnings ratios
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