Peter Norman Sørensen publishes paper in American Economic Review

Price Reaction to Information with Heterogeneous Beliefs and Wealth Effects: Underreaction, Momentum, and Reversal

Peter Norman Sørensen and his co-author summarize the prestigious publication in these words: "This paper analyzes how asset prices in a binary market react to information when traders have heterogeneous prior beliefs. We show that the competitive equilibrium price underreacts to information when there is a bound to the amount of money traders are allowed to invest. Underreaction is more pronounced when prior beliefs are more heterogeneous. Even in the absence of exogenous bounds on the amount that traders can invest, prices underreact to information provided that traders become less risk averse as their wealth increases. In a dynamic setting, underreaction results in initial momentum and then reversal in the long run."

Ottavani and Sørensen formulate a trading model for a binary event. They state:

"Traders can take positions in two Arrow-Debreu contingent assets, each paying one dollar if the corresponding outcome occurs. Our underreaction result hinges on three characteristics of asset markets:

• Traders have heterogeneous prior beliefs, given their limited experience with the underlying event contingent on which the asset pays. These initial opinions are subjective and thus are uncorrelated with the realization of the outcome. Having different prior beliefs, traders gain from trading actively.
• Traders have access to public information (such as an earnings announcement) about the eventual realization of the outcome on which the market is liquidated. Information has an objective nature because it is correlated with the outcome.
• Traders exhibit wealth effects, which can take one of two forms. Initially, we develop the intuition for underreaction in a simple setting in which traders are risk neutral but are exogenously bounded by their limited wealth. We then turn to a more standard setting with risk averse traders who endogenously limit their positions on the risky assets, and show that underreaction results when wealthier traders are willing to take on more risk.

[…] Our main contribution is the observation that the market price systematically underreacts to information, rather than behaving like a posterior belief. Initially, we focus on the case in which each trader's endowment is constant with respect to the outcome realization, so that trade is only motivated by differences in prior beliefs"

A full text preprint of the publication is accessible here.

This article is the result of the cooperation between Peter Normann Sørensen from Department of Economics at University of Copenhagen and Marco Ottaviani from Bocconi University.