Extreme Events and Overreaction to News
87 Pages Posted: 8 Jan 2021 Last revised: 14 Jul 2021
Date Written: November 2, 2020
The presence of both systematic under-and-overreaction to news in financial markets is a major puzzle. We propose a systematic predictor of under-and-overreaction to news: the extremeness of the associated distribution of fundamentals. Using a comprehensive database of corporate news events, we identify substantial heterogeneity in both reactions to news and extremeness of fundamentals across types of corporate events. We document overreaction to more extreme event-types, such as leadership changes, M&A, and customer announcements, and underreaction to less extreme event-types such as earnings announcements. We show this is consistent with diagnostic expectations, a model of belief formation based on the representativeness heuristic. The model further predicts greater trading volume holding fixed fundamentals and more sensitive belief changes to more extreme corporate events, which we confirm in the data. We calibrate our model and show that it quantitatively matches the key features in our data.
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