Conservatism Bias and Asset Price Overreaction or Underreaction to New Information in a Competitive Securities Market
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This chapter proves that conservatism bias is capable of causing the asset price to overreact or underreact to good news or bad news. These results are obtained in a static equilibrium model of a competitive securities market. In the market, there are two types of assets: risk-free asset and risky asset. The payoff for the risk-free asset is one and the payoff for the risky asset is normally distributed. There are three types of traders: rational traders, conservatism traders and noise traders. Noise traders trade for liquidity reasons and hence, their demand for the risky asset is assumed to be random. Before any trade takes place, rational and conservatism traders receive an informational signal about the asset payoff. Due to the conservatism bias, conservatism traders are slow to update their beliefs about the asset payoff relative to rational traders after receiving the new information.