Price Reaction to Momentum Trading and Market Equilibrium

Abstract

This paper analyzes a nancial market with momentum trading, and shows how momentum trading a ects the market equilibrium. When momentum traders dominate the market, the private information owned by the rational traders may not be incorporated into the price, whence the price becomes less informative. If trend-chasing traders trade intensively in the market, a market bubble may occur and the price rises even though the fundamental value of the asset is low. It is shown that the reliability of the rm's public announcement such as an earnings forecast is a key factor to avert the market bubble.