Probability Weighting and Asset Prices: Evidence from Mergers and Acquisitions

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