RFS Advance Access published online on June 27, 2008
Review of Financial Studies, doi:10.1093/rfs/hhn062
Information in Equity Markets with Ambiguity-Averse Investors
UCLA, Anderson School of Management
Address correspondence to Judson A. Caskey, UCLA, Anderson School of Management, 110 Westwood Plaza, D416, Los Angeles, CA 90095; Telephone: (310) 206-1503, Fax: (310) 267-2193; e-mail: judson.caskey{at}anderson.ucla.edu
JEL Classification: D81, G11, G14
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Abstract |
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This paper shows that persistent mispricing is consistent with a market that includes ambiguity-averse investors. In particular, ambiguity-averse investors may prefer to trade based on aggregate signals that reduce ambiguity at the cost of a loss in information. Equilibrium prices may therefore fail to impound publicly available information. While this creates profit opportunities for ambiguity-neutral investors, ambiguity-averse investors perceive that the benefit of ambiguity reduction outweighs the cost of trading against investors who have superior information. The model can explain both underreaction, such as that evident in postearnings announcement drifts and momentum, and overreaction to accounting accruals.
This paper is based on my dissertation at the University of Michigan’s Stephen M. Ross School of Business. I would like to thank my dissertation committee members Ilia Dichev, Raffi Indjejikian (chair), Russell Lundholm, M. P. Narayanan, and Emre Ozdenoren. I am grateful for comments from Michelle Hanlon, Jack Hughes, David Hirshleifer, Jing Liu, Matthew Spiegel (the editor), Avanidhar Subrahmanyam, Brett Trueman, two anonymous referees, and seminar participants at University of California, Irvine, UCLA, University of Chicago, Dartmouth College, Emory University, University of Georgia and University of Michigan. I gratefully acknowledge financial support from the Deloitte Foundation, the Paton Fund, the Ross School of Business, and the Anderson School of Management.