Bayesian Investor Belief Updating Speed and Market Underreaction to Earnings Announcements

Abstract

AbstractBuilding on the Bayesian Theorem, we propose a multi‐period market microstructure model to understand how Bayesian investors underact new information and the duration of market underreaction. Applying the model to post‐earnings‐announcement drifts, our simulation and regression analyses show that the duration of the post‐announcement price adjustment process and the post‐announcement drifts can be explained by the new measure of belief updating speed that quantifies the uncertainties faced by Bayesian investors when incorporating new information into prices. Our study highlights the importance of incorporating the belief uncertainties of uninformed investors in explaining market underreaction in the Bayesian framework.