Abstract
The answer depends on the type of shock. This paper presents and tests a simple model to help understand the differing market responses to positive and negative shocks; and to shocks that are accompanied by news, or not. In the model pricing is determined by the interactions of rational arbitrageurs, retail traders, and liquidity traders. The rational arbitrageurs are constrained by their limited capital in the short run. The retail traders do not monitor the market continuously. When there is news, they may overreact. The liquidity traders trade for reasons that are independent of market pricing. The model predicts over-reaction to good news and under-reaction to bad news on the news date. Both patterns are stronger when the arbitrage capital is scarce, and when the attention bias is stronger. Price shocks that are not accompanied by news are generally reversed subsequently. Using a comprehensive data set of Financial Times news stories about S&P 500 firms from 1982-2013, we find empirical support for the predictions.
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