Critical Analysis of the Implication of Overreaction to the Return Predictability in Uk Stock Market

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Critical analysis of the implication of overreaction to the return predictability in UK stock market

Over the past decades, overreaction has drawn attention from many economic researchers, the most significant studies being Jegadeesh and Titman, (1993), De Bondt and Thaler (1985) proving the existence of overreaction. In their framework, they violated the EMH assumption. Then many later studies examined the overreaction effect through different market anomalies with One of the important anomalies being arbitrage trading strategies.

This paper will follow the Jegadeesh and Titman, (1993) framework and the Hons and Tonks (2002) method to construct a momentum strategy for UK market with winner and loser portfolio. The aim of this research is to examine if overreaction trends can be predicted and used to generate arbitrage trading profit.

In this paper, the finding suggested there is no overreaction in the UK FTSE 100 stock market. Due to the sample being big companies, the absence of small companies may have diminished the overreaction effect.

I would like to take this opportunity to express my appreciation to all the teaching staff with their help and especially my tutor Toby Watson who has given me a lot of attention and valuable advice to help me through the whole dissertation process.

Table of Content

Chapter 1 Introduction
1.1 Research Aim
1.2 Research Objective
1.3 Structural layout of research
Chapter 2 Literature Review
2.1 Overreaction Hypothesis

2.2 A criticism of efficient market hypothesis on return predictability

2.3 A relation between investors decision making and stock return

2.4 Measurement interval on overreaction study

2.5 Overreaction in UK market

2.6 Overreaction versus sizes effect

2.7 Trading strategies to determine overreaction

2.8 Overreaction to return predictability

Chapter 3 Methodology
3.1 Data

3.2 Portfolio formation based on momentum strategy

3.3 Testing the return predictability

Chapter 4 Data Analysis
4.1 Momentum strategy: Winner- Loser portfolio (3 years holding period)

4.2 Momentum strategy: Winner- Loser portfolio (12 months holding)

4.3 Compare finding with previous literature

Chapter 5 Conclusion


Chapter 1 Introduction

According to efficient market hypothesis, information affects security price performance. If this theory holds, security price should be at equilibrium to its fundamental value as its fair price. However, efficient market hypothesis does not perfectly hold at all time and it is known as the weak form EMH that security price does not fully reflect the information. De Bondt and Thaler (1985) suggested the overreaction hypothesis where the security price is overvalued when there is a new or an event comes into the market.

1.1 Research Aim

Based on the theory from overreaction hypothesis, investors tend to overreact to the news and events which can create an impact to the security price. Due to this implication, securities tends to be over-bought or over-sold unrelating to its fundamental value. Based on this market anomaly, investors should be able to generate abnormal stock return based on appropriate investment strategy. This research will draw on Jegadeesh and Titman, (1993) overreaction hypothesis and the study from Clare and Thomas (1995) in the UK market. As overreaction has been proved in UK market; thus if the level of overreaction can be estimated, investors should be able to predict the excess return from the market anomalies. This paper will be using momentum strategy by Hon and Tonks (2002) to construct a winner and loser portfolio and prove that the overreaction pattern is predictable hence profit can be generated by predicting the overreaction trend As a result, the finding of this paper should provided evidences on overreactions return predictability in UK stock market.

1.2 Research Objective

As the overreaction hypothesis has been identified in UK market from...
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