Trading Volume and Price Reactions to Public Announcements

Abstract

The purpose of this study is to investigate theoretically how the price and volume reactions to a public announcement are related to each other, to the announcement's characteristics, and to the traders' beliefs at the time of the announcement. Among many possible sources of (abnormal) trading volume at the time of a public announcement, our emphasis in this study is on differences in the quality of preannouncement information. The study uses a two-period rational expectations model. Traders achieve their optimal portfolios prior to the announcement by trading on what each knows in the preannouncement period. The public announcement changes traders' beliefs and induces them to engage in a new round of trade. It is assumed that traders are diversely informed and differ in the precision of their private prior information; they therefore respond differently to the announcement, and this leads to positive volume. We obtain three results. First, the price change at the time of announcement is proportional to both the unexpected portion of the announcement and its relative importance across the posterior beliefs of traders. This relative importance is increasing in the precision of the announcement and decreasing in the precision of the preannouncement information.