DP13857 Sentiment and Speculation in a Market with Heterogeneous Beliefs

Author(s): Ian Martin, Dimitris Papadimitriou
Publication Date: July 2019
Keyword(s): Excess Volatility, heterogeneous beliefs, sentiment, Speculation, target prices
JEL(s): E44, G02, G11, G12, G13
Programme Areas: Financial Economics, Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13857

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.