The overreaction effect is an economic phenomenon that explains why exchange rates are sometimes more volatile than normal. It is also known by its English name, overshooting.
When an event occurs (change of monetary policy for example) that affects currencies, investors act in the market buying or selling according to that event. On many occasions the price of currencies increases (or decreases) more than one would expect for that event, that excessive increase is known as overreaction. The exchange rate overreacts before reaching its new equilibrium.
Some economists argued that volatility arose as a result of speculation and market inefficiency. However, the overreaction model argues that exchange rates will vary temporarily to events to compensate for price stagnation in the economy. Therefore, there will be a temporary overreaction in the market, which will later be corrected by adjusting the exchange rate to the adjustment made by that event.
Overreaction can be explained because when there is a monetary stimulus, the financial asset market and the goods market do not adjust at the same rate, but the financial one adjusts almost immediately, while the goods market takes time to adjust.
Like the momentum effect, the overreaction effect violates the principle of market efficiency .
Overreaction effect of other assets
The overreaction effect also refers to the event that occurs in actions that had little revaluation for several years but then have a better behavior than the rest of the actions. This pattern is attributed to overreaction to bad and good news. The value investors often use these patterns to detect undervalued companies.
Overreaction also occurs in the fixed income market ( bonds ) and other financial markets when investors react to news or economic events.
Origin of the overreaction concept
The term overshooting was first used in 1976 by German economist Rudi Dornbusch in his book “Expectations and exchange rate dynamics”. It is currently known as Dornbusch overreaction model.