Stock Overreaction to Extreme Market Events
40 Pages Posted: 22 Feb 2015
Date Written: January 12, 2015
In this paper we find that stocks overreact to both positive and negative extreme daily movements of the broader market, but more intensely in the latter case. The overreaction is even more pronounced when the market exhibits clustered extreme swings, indicating that the overreaction is related to market volatility. Indeed, a contrarian investment strategy earns a significant Fama-French daily alpha of 0.34% (85.68% annualized) with a Sharpe ratio of 5.23 in highly volatile circumstances. Stock overreaction appears to be driven by the loser stocks that revert more strongly, even as they exhibit a lower market beta than the winners.
Keywords: Overreaction, contrarian strategy, momentum crash, market efficiency, extreme market events
JEL Classification: G14, G15
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