The Dynamics of Belief Formation and Price Momentum
Posted: 3 Feb 2017
Date Written: February 2, 2017
In classical perfect and complete markets prices form a Martingale and stock returns (or equivalently, successive price changes) are serially uncorrelated. However, there is evidence that stock returns are serially correlated in both the short and the long-term; this has been construed as a market anomaly, a violation of semi strong efficiency. 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, 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
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