A pseudo-Bayesian model for stock returns in financial crises

Eric S. Fung, Kin Lam, Tak-Kuen Siu, Wing-Keung Wong

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Abstract

Recently, there has been a considerable interest in the Bayesian approach for explaining investors' behaviorial biases by incorporating conservative and representative heuristics when making financial decisions, (see, for example, Barberis, Shleifer and Vishny (1998)). To establish a quantitative link between some important market anomalies and investors' behaviorial biases, Lam, Liu, and Wong (2010) introduced a pseudo-Bayesian approach for developing properties of stock returns, where weights induced by investors' conservative and representative heuristics are assigned to observations of the earning shocks and stock prices. In response to the recent global financial crisis, we introduce a new pseudo-Bayesian model to incorporate the impact of a financial crisis. Properties of stock returns during the financial crisis and recovery from the crisis are established. The proposed model can be applied to investigate some important market anomalies including short-term underreaction, long-term overreaction, and excess volatility during financial crisis. We also explain in some detail the linkage between these market anomalies and investors' behavioral biases during financial crisis.
Original languageEnglish
Pages (from-to)43-73
Number of pages31
JournalJournal of risk and financial management
Volume4
Issue number1
DOIs
Publication statusPublished - 2011

Bibliographical note

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Keywords

  • Bayesian model
  • representative and conservative heuristics
  • under- reaction
  • overreaction
  • stock price
  • stock return
  • financial crisis

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