Discussion paper

DP13857 Sentiment and Speculation in a Market with Heterogeneous Beliefs

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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Citation

Martin, I and (eds) (2019), “DP13857 Sentiment and Speculation in a Market with Heterogeneous Beliefs”, CEPR Press Discussion Paper No. 13857. https://cepr.org/publications/dp13857