One of the most popular explanations for momentum in asset prices is known as under- reaction. (Remember that momentum is the phenomenon that an asset that increased in price recently continues to increase in price in the short run. And assets that experienced a price decline continue to fall on average in the short run.) Under-reaction means that when an asset has some news (lets say good news), the market price goes up but not the whole amount. That means at first the stock under-reacts to the news, and then over time it continues to go up as the information is eventually completely processed.

1. a) Assume that under-reaction is the reason we see momentum in asset prices. If the amount of overconfidence among investors increases, do you expect there to be an increase or decrease in momentum?

2. b) Consider a stock market where investors learn information about firms through word- of-mouth. That is, one investor learns some news, then tells some friends, who then tell some other friends, etc. Would you expect such a stock market to exhibit more or less momentum than an alternative stock market where investors tend to learn news about firms from national television broadcasts?