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

52 Pages Posted: 20 Oct 2007

See all articles by Frank Welfens

Frank Welfens

University of Mannheim

Martin Weber

University of Mannheim - Department of Banking and Finance

Date Written: October 2007

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 underreaction models like Grinblatt and Han (2005), we conclude based on our findings 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.

Keywords: momentum, disposition effect, market experiment

JEL Classification: C91, D14, D81, G11

Suggested Citation

Welfens, Frank and Weber, Martin, How do Markets React to Fundamental Shocks? An Experimental Analysis on Underreaction and Momentum (October 2007). Available at SSRN: https://ssrn.com/abstract=1022924 or http://dx.doi.org/10.2139/ssrn.1022924

Frank Welfens (Contact Author)

University of Mannheim ( email )

D-68131 Mannheim
Germany
+49 621 181 1539 (Phone)
+49 621 181 1534 (Fax)

Martin Weber

University of Mannheim - Department of Banking and Finance ( email )

D-68131 Mannheim
Germany
+49 621 181 1532 (Phone)
+49 621 181 1534 (Fax)

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