Sentiment and speculation in a market with heterogeneous beliefs

Martin, Ian and Papadimitriou, Dimitris (2019) Sentiment and speculation in a market with heterogeneous beliefs. Financial Markets Group Discussion Papers (785). Financial Markets Group, The London School of Economics and Political Science, London, UK.

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Abstract

We present a dynamic model featuring risk-averse investors with heterogeneous beliefs. Individual investors have stable beliefs and risk aversion, but agents who were correct in hindsight become relatively wealthy; their beliefs are overrepresented in market sentiment, so "the market" is bullish following good news and bearish following bad news. Extreme states are far more important than in a homogeneous economy. Investors understand that sentiment drives volatility up, and demand high risk premia in compensation. Moderate investors supply liquidity: they trade against market sentiment in the hope of capturing a variance risk premium created by the presence of extremists.

Item Type:	Monograph (Discussion Paper)
Official URL:	https://www.fmg.ac.uk/
Additional Information:	© 2019 The Authors
Divisions:	Finance
Subjects:	H Social Sciences > HC Economic History and Conditions H Social Sciences > HG Finance
JEL classification:	D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D81 - Criteria for Decision-Making under Risk and Uncertainty D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D83 - Search; Learning; Information and Knowledge; Communication; Belief G - Financial Economics > G1 - General Financial Markets > G11 - Portfolio Choice; Investment Decisions G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing; Trading volume; Bond Interest Rates
Date Deposited:	31 May 2023 23:03
Last Modified:	16 Sep 2023 00:00
URI:	http://eprints.lse.ac.uk/id/eprint/118936

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