Probability Weighting and Asset Prices: Evidence from Mergers and Acquisitions

60 Pages Posted: 8 Feb 2014 Last revised: 24 Mar 2017

See all articles by Baolian Wang

Baolian Wang

University of Florida - Department of Finance, Insurance and Real Estate

Date Written: March 02, 2017

Abstract

For mergers and acquisitions with a small failure probability, the average decline in target stock price if the deal fails is much larger than the average increase that accompanies deal success. Probability weighting implies that the deal failure probability of such target stocks will be overweighted, leading them to be undervalued. I find strong evidence in support of this prediction. A trading strategy based on this prediction delivers around 1% abnormal return per month, with negative beta and negative downside risk exposure. The abnormal returns cannot be explained by a preference for positive skewness under traditional (expected) utility models, and are stronger when arbitrage is more difficult.

Keywords: Mergers and acquisitions, Probability weighting, Cumulative prospect theory

JEL Classification: D03, G12, G34

Suggested Citation

Wang, Baolian, Probability Weighting and Asset Prices: Evidence from Mergers and Acquisitions (March 02, 2017). Available at SSRN: https://ssrn.com/abstract=2392123 or http://dx.doi.org/10.2139/ssrn.2392123

Baolian Wang (Contact Author)

University of Florida - Department of Finance, Insurance and Real Estate ( email )

314 Stuzin Hall
Gainesville, FL 32611
United States

HOME PAGE: http://www.wangbaolian.com

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