Asset Price Response to New Information by Guo Ying Luo

Author:Guo Ying Luo
Language: eng
Format: epub
Publisher: Springer New York, New York, NY

(4.12)

Also, substituting Eq. (4.12) into Eq. (4.9) gives rise to the demand function for heuristic traders as:

(4.13)

Similarly, substituting Eq. (4.12) into Eq. (4.10) results in the demand function for heuristic traders as5:

(4.14)

4.3 The Results

This section analyzes how the representativeness heuristic causes the asset price to overreact or underreact to good news or bad news in the case of noise traders being net buyers or sellers of the asset.

Before the analysis, the definitions needed for the analysis are first specified below:

The asset price overreaction to an informational signal occurs if in response to the informational signal, rational traders buy (sell) the asset and at the same time, the asset price is higher (lower) than what it would be in the market with rational traders and noise traders. On the other hand, the asset price underreaction to an informational signal occurs if in responding to the informational signal, rational traders buy (sell) the asset and at the same time, the asset price is not as high (low) as it would be in the market with rational traders and noise traders.

In addition, the definitions of good news and bad news are as follows. An informational signal is considered as bad news if the signal is smaller than the expected payoff of the asset; otherwise, the informational signal is considered as good news. Furthermore, according to how far the informational signal is greater than the expected payoff of the asset, the good news is further classified as slightly good news if , very good news if , where , and extremely good news if . Similarly, based on how far the informational signal is smaller than the expected payoff of the asset, bad news is further classified as slightly bad news if , very bad news if , and extremely bad news if .

In addition, to analyze whether the asset price is greater than , the equation for is computed from Eqs. (4.1) and (4.12) as:

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