Testing Behavioral Finance Models of Market Under- and Overreaction: Do They Really Work?

45 Pages Posted: 4 Jan 2006

See all articles by Asad Kausar

Asad Kausar

American University - Kogod School of Business; Nanyang Technological University (NTU); Nanyang Technological University

Richard Taffler

Manchester Business School

Date Written: November 29, 2005

Abstract

We test the predictions of the three main behavioral finance theories of market under- and overreaction using out-of-sample data conditional on the nature of the news using the going-concern audit opinion (bad news event) and its withdrawal (good news event). We find strong support for the Daniel, Hirshleifer and Subrahmanyam (1998) model for our bad news as well as the good news case suggesting that market underreaction to going-concern opinions is a consequence of prior market overreaction resulting from incorrect classification of going-concern firms by investors into trending regimes. In contrast, we find no support for the Barberis, Shleifer and Vishny (1998) or Hong and Stein (1999) models in our event-study setting in either the bad or good news cases. Our results have a number of implications relating to the value of such theoretical behavioral finance models in practice. We also highlight the central role of the limits-to-arbitrage assumption when testing such behavioral finance theories.

Keywords: finance, under- and overreaction models, limits to arbitrage, going-concern

JEL Classification: G14, M40

Suggested Citation

Kausar, Asad and Taffler, Richard J., Testing Behavioral Finance Models of Market Under- and Overreaction: Do They Really Work? (November 29, 2005). Available at SSRN: https://ssrn.com/abstract=873615 or http://dx.doi.org/10.2139/ssrn.873615

Asad Kausar (Contact Author)

American University - Kogod School of Business ( email )

4400 Massachusetts Avenue NW
Washington, DC 20816-8044
United States

Nanyang Technological University (NTU) ( email )

S3 B2-A28 Nanyang Avenue
Singapore, 639798
Singapore

Nanyang Technological University ( email )

Nanyang Business School
Singapore, 639798
Singapore

Richard J. Taffler

Manchester Business School ( email )

Crawford House
Oxford Road
Manchester M13 9PL
United Kingdom

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