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R2 and Price Inefficiency

Kewei Hou
Ohio State University - Department of Finance

Lin Peng
Zicklin School of Business, Baruch College / CUNY

Wei Xiong
Princeton University - Department of Economics; National Bureau of Economic Research (NBER)


November 5, 2006

Fisher College of Business Working Paper No. 2006-03-007
Charles A. Dice Center Working Paper No. 2006-23

Abstract:     
Motivated by the recent debate on return R2 as an information-efficiency measure, this paper proposes and examines a new hypothesis that R2 is related to investors' biases in processing information. We provide a model to show that R2 decreases with the degree of the marginal investor's overreaction to firm-specific information. This theoretical result motivates an empirical hypothesis that stocks with lower R2 should exhibit more pronounced overreaction-driven price momentum. Empirically, we confirm that such a negative relationship between R2 and price momentum exists, and find this relationship robust to controls for risk as well as several alternative mechanisms, such as slow information diffusion, information uncertainty, fundamental R2 and illiquidity. Furthermore, we also document stronger long-run price reversals for stocks with lower R2. Taken together, our results suggest that return R2 could be related to price inefficiency.

JEL Classifications: G12, G14

Working Paper Series

Date posted: January 02, 2007 ; Last revised: March 15, 2007

Suggested Citation

Hou, Kewei, Xiong, Wei and Peng, Lin, R2 and Price Inefficiency (November 5, 2006). Fisher College of Business Working Paper No. 2006-03-007; Charles A. Dice Center Working Paper No. 2006-23. Available at SSRN: http://ssrn.com/abstract=954559


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Contact Information

Kewei Hou (Contact Author)
Ohio State University - Department of Finance ( email )
2100 Neil Avenue
Columbus, OH 43210-1144
United States
614-292-0552 (Phone)
614-292-2418 (Fax)

Lin Peng
Zicklin School of Business, Baruch College / CUNY ( email )
17 Lexington Ave., Box B10-225
New York, NY 10010
United States
(646)312-3491 (Phone)
(646)312-3451 (Fax)
Wei Xiong
Princeton University - Department of Economics ( email )
Princeton, NJ 08544-1021
United States
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
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