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.