Discussion Paper Details

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Title: Sentiment and Speculation in a Market with Heterogeneous Beliefs

Author(s): Ian Martin and Dimitris Papadimitriou

Publication Date: July 2019

Keyword(s): Excess Volatility, heterogeneous beliefs, sentiment, Speculation and target prices

Programme Area(s): Financial Economics and Monetary Economics and Fluctuations

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.

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Bibliographic Reference

Martin, I and Papadimitriou, D. 2019. 'Sentiment and Speculation in a Market with Heterogeneous Beliefs'. London, Centre for Economic Policy Research.