Prospect Theory and Market Response to Public Announcements

In this paper I develop a noisy-rational-expectations model with a risk-neutral market maker and speculators who display prospect theory-inspired preferences and who can acquire private information about a public announcement prior to its release. Private information acquisition decreases the market response to the public announcement, as trading on this information increases the informativeness of prices prior to the announcement. Increasing loss-aversion increases the market response to the public announcements, as loss-averse speculators acquire less private information and trade less on this information. Increasing the preferences for risk-seeking in losses decreases the change in informativeness but increases price variance, providing an ambiguous effect on the market response. Overall, prospect theory-inspired preferences in the economy increase the market response to the public signal as loss-aversion dominates the effect of risk-seeking in losses for any reasonable parameter choices. These results are important for regulators deciding on accounting standards, on hindering insider trading and for both managers' and investors' decisions surrounding public announcements, when the market can be characterized by prospect theory-inspired preferences