Limited Attention, Uncertainty, and Asset Price Dynamics

Abstract

Standard neoclassical models in finance assume that individuals form expectations and make decisions using all available information. While these theories dictate that new information is instantaneously incorporated into asset prices, our minds and cognitive resources are finite and we allocate our attention selectively. Moreover, the amount of information relevant to the valuation of an asset is far from trivial in the current information society. This has important implications for asset pricing because attention is a prerequisite for distilling and processing information into prices. The underlying motivation of the empirical essays in this dissertation is to better understand the implications of boundedly rational market participants and to examine the role of limited attention. Using innovative datasets to measure attention, it provides new insights into how limited attention affects the expectation formation and behavior of financial agents, such as investors and analysts, and how this ultimately feeds into asset price dynamics. In this way, this dissertation contributes to a further development of the finance discipline from its neoclassical foundations towards a more realistic approach that integrates behavioral phenomena. In the first chapter we empirically test the rational inattention model for exchange rates. Rational inattention theory provides a framework of how cognitively limited agents might simplify and summarize available information. The framework is particularly suitable to study the relationship between exchange rates and fundamentals, because exchange rates are largely determined by expectations of market participants. Our results provide strong evidence in favor of the rational inattention theory of exchange rates. In the second chapter we examine (i) the effect of economic policy uncertainty (EPU) on the forecasts of professional equity analysts, (ii) how EPU affects analysts’ attention allocation to the overall stock market and to firm-specific news, and (iii) how EPU influences the information incorporated in stock prices. We show that periods of higher EPU are associated with higher analyst disagreement and decreased forecast accuracy. Also, analysts issue on average more pessimistic forecasts when EPU is high and ‘walk down’ their forecasts when the announcement comes closer. Second, we show that higher levels of EPU are associated with higher attention to the overall stock market, but with lower firm-level attention, and that forecast errors have a larger firm-specific component during high EPU. Finally, we demonstrate that investors do not fully unravel the decrease in forecast accuracy during high EPU, providing further evidence that investors tend to follow analyst forecasts. This has important implications for stock pricing, because when prices do not reflect the earnings news associated with the predictable component of forecast errors, the price discovery process may be affected. In the third chapter we examine the role of investor attention in the period of financial turbulence during the coronavirus pandemic. We investigate the role of what we call pandemic attention, the amount of attention paid to pandemic news, on stock markets’ behavior. We show that the allocation of attention is an important determinant of investor behavior during the pandemic, beyond health news, sentiment and other relevant factors. We show that pandemic attention has asymmetrically influenced stock market dynamics during the pandemic (negatively in bearish circumstances, positively in bullish markets). Secondly, we show that pandemic numbers and sentiment in the media covering the pandemic only had an effect on stock returns if sufficient attention was paid to it. Third, we show that higher levels of pandemic attention are associated with higher stock market volatility and comovement. Finally, we provide evidence that the higher comovement can be explained by limited attention: market participants prioritize market-wide developments above other sources of news, such that pandemic attention reduces the attention paid to firm-specific news.