Probability Weighting and Asset Prices: Evidence from Mergers and Acquisitions

Abstract

For mergers and acquisitions with a small failure probability, the average decline in target stock price if the deal fails is much larger than any increase that accompanies deal success. Probability weighting implies that the deal failure probability of such target stocks will be overweighted, leading them to be undervalued. I test whether investors are averse to holding such stocks and find strong supporting evidence. Target stocks with lower ex-ante failure probability yield positive abnormal returns, but other targets do not generate significant abnormal returns. A trading strategy that buys target stocks with low ex-ante failure probability and sells short target stocks with high ex-ante failure probability delivers around 1% abnormal return per month. These abnormal returns are not subsumed by a preference for positive skewness under traditional (expected) utility models; in fact, target stocks with lower ex-ante failure probability have lower betas, lower volatilities, and lower downside risk. I also find that profits from the strategy are significantly higher when arbitrage is more difficult.