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The Dynamics of Belief Formation and Price Momentum

50 Pages Posted: 3 Feb 2017  

Alex Dontoh

New York University (NYU) - Department of Accounting

Joshua Ronen

New York University (NYU) - Department of Accounting

Bharat Sarath

Rutgers, The State University of New Jersey - Accounting

Date Written: January 2, 2017

Abstract

In classical perfect and complete markets, prices form a Martingale and stock returns (or equivalently, successive price changes) are serially uncorrelated. However, there is considerable evidence in the finance literature showing that stock returns are serially correlated both in the short and the long-term. This empirical phenomenon has been viewed as a violation of semistrong efficiency and has resulted in considerable discussion in the literature. In this paper we demonstrate that within a multi-period noisy rational expectations equilibrium framework, a first order autoregressive (AR-1) liquidity trading process, by itself, suffices to give rise to systematic correlations in price changes, either positive or negative, depending on the specific parameters of the process, even if the (unknown) underlying liquidation value is fixed. That is, unsystematic random fluctuations in observed prices arising from factors such as liquidity trading affect Bayesian belief formation, and thereby trading strategies, in such a way that equilibrium price changes can manifest both momentum and reversals.

Keywords: Noisy Rational Expectations, Multi-period model, Price Momentum

JEL Classification: C61, C73, D47, D53

Suggested Citation

Dontoh, Alex and Ronen, Joshua and Sarath, Bharat, The Dynamics of Belief Formation and Price Momentum (January 2, 2017). Available at SSRN: https://ssrn.com/abstract=2910570

Alex Dontoh

New York University (NYU) - Department of Accounting ( email )

40 West 4th Street, Suite 400
Suite 10-180
New York, NY 10012-1118
United States
212-998-0064 (Phone)
212-995-4004 (Fax)

Joshua Ronen

New York University (NYU) - Department of Accounting ( email )

40 West 4th Street, Suite 400
Suite 10-180
New York, NY 10012-1118
United States
212-998-4144 (Phone)
212-995-4599 (Fax)

HOME PAGE: http://www.stern.nyu.edu/~jronen/

Bharat Sarath (Contact Author)

Rutgers, The State University of New Jersey - Accounting ( email )

94 Rockafeller Road
Piscataway, NJ 08854
United States

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