AMBIGUITY, MARKET UNDERREACTION, AND POST-EARNINGS ANNOUNCEMENT DRIFTS

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2024

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We demonstrate that investors underreact to earnings news of firms with high levels of ambiguity, which is associated with distinct post-earnings announcement drifts (PEAD). The effect of ambiguity is stronger than many factors in explaining underreaction and PEAD. The market underreaction is associated with less information acquisition during the earnings announcement period. The market underreaction is stronger for firms with poorer information environments, higher limits to arbitrage, and higher levels of closest peers’ ambiguity, while it is weaker for firms with higher (non-transient) institutional ownership. Taking advantage of the market underreaction, we demonstrate that a “fund-of-funds” portfolio formed on firms’ ambiguity and earnings surprises yields an annual abnormal return of 15.7%. Overall, our results show that ambiguity leads to stock market inefficiency.

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Finance, Ambiguity, Knightian Uncertainty, Market Underreactions, Post-earnings Announcement Drifts

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89 pages

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