Hot Potatoes: Underpricing of Stocks following Extreme Negative Returns

Abstract

Although it is well established that investors are willing to accept a negative premium for lottery-like stocks, it is puzzling that the opposite effect is not observed in stocks experiencing large daily losses. We find that stocks that experience large negative daily returns (MIN) also display large positive daily returns (MAX); therefore the MIN effect is subdued. Once stocks ranked as high-MAX within MIN deciles are removed, we find that MIN positively predicts future stock returns. More importantly, a strategy that buys pure high-MIN stocks and shorts pure high-MAX stocks generates superior returns compared to stand-alone MAX and/or MIN strategies.

Keywords: extreme returns, maximum daily losses, underpricing

JEL Classification: G11, G12, G17