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R2 and Price Inefficiency

Fisher College of Business Working Paper No. 2006-03-007

Charles A. Dice Center Working Paper No. 2006-23

50 Pages Posted: 2 Jan 2007  

Kewei Hou

Ohio State University (OSU) - Department of Finance

Wei Xiong

Princeton University - Department of Economics; National Bureau of Economic Research (NBER)

Lin Peng

Baruch College/CUNY - Zicklin School of Business

Date Written: November 5, 2006

Abstract

Motivated by the recent debate on return R2 as an information-efficiency measure, this paper proposes and examines a new hypothesis that R2 is related to investors' biases in processing information. We provide a model to show that R2 decreases with the degree of the marginal investor's overreaction to firm-specific information. This theoretical result motivates an empirical hypothesis that stocks with lower R2 should exhibit more pronounced overreaction-driven price momentum. Empirically, we confirm that such a negative relationship between R2 and price momentum exists, and find this relationship robust to controls for risk as well as several alternative mechanisms, such as slow information diffusion, information uncertainty, fundamental R2 and illiquidity. Furthermore, we also document stronger long-run price reversals for stocks with lower R2. Taken together, our results suggest that return R2 could be related to price inefficiency.

JEL Classification: G12, G14

Suggested Citation

Hou, Kewei and Xiong, Wei and Peng, Lin, R2 and Price Inefficiency (November 5, 2006). Fisher College of Business Working Paper No. 2006-03-007; Charles A. Dice Center Working Paper No. 2006-23. Available at SSRN: https://ssrn.com/abstract=954559 or http://dx.doi.org/10.2139/ssrn.954559

Kewei Hou (Contact Author)

Ohio State University (OSU) - Department of Finance ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States
614-292-0552 (Phone)
614-292-2418 (Fax)

Wei Xiong

Princeton University - Department of Economics ( email )

Princeton, NJ 08544-1021
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Lin Peng

Baruch College/CUNY - Zicklin School of Business ( email )

17 Lexington Ave., Box B10-225
New York, NY 10010
United States
(646)312-3491 (Phone)
(646)312-3451 (Fax)

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