Information diffusion and the boundary of market efficiency

This dissertation investigates the boundary of market efficiency theoretically and empirically. It suggests that a diffusion mechanism exists in capital markets. A stylized information diffusion model is presented to describe the process that investors gradually assimilate the information following an information event in capital markets. The model suggests that a diffusion process depends on both a drift and a diffusion force. If prices have converged before the drift force disappears, the diffusion phenomenon is difficult to observe. Otherwise, the diffusion force dominates in longer horizon and imposes a boundary on market efficiency. The model indicates that the speed of information diffusion depends on information content, information conductivity, and information shock absorption capacity. Each signal has a different degree of information content and each firm has a unique information conductivity. Consequently, the information on different firms diffuses across investors at different rates.; Several implications from this diffusion model are tested with quarterly earnings announcement data. Post-announcement-drift is documented only for earnings announcements that have high information uncertainty (content), measured by high abnormal trading volume and return volatility surrounding the announcement. The results are robust after controlling for the magnitude of earnings surprise. Preliminary evidence also suggests that the magnitude of drift for good (bad) news firms are positively (negatively) related to analyst following and institutional ownership. Moreover, price movement after a second earnings announcement is affected by the information contained in the previous announcement. These findings are consistent with an information diffusion process at work in capital markets.