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Equilibrium Portfolio Strategies in the Presence of Sentiment Risk and Excess Volatility

Subject

Finance

Publishing details

Authors / Editors

Dumas B;Kurshev A;Uppal R

Publication Year

2007

Abstract

Our objective is to identify the trading strategy that would allow an investor to take advantage of "excessive" stock price volatility and "sentiment" fluctuations. We construct a general-equilibrium "difference-of-opinion" model of sentiment in which there are two classes of agents, one of which is overconfident about a public signal, while still being intertemporal optimizers. The overconfident investors overreact to the signal and change their expectations too often, sometimes being excessively optimistic, sometimes being excessively pessimistic. They thereby introduce an additional risk factor, cause stock prices to be excessively volatile, and induce rational invstors to be conservative in their bond and equity investment. Moreover, the rational investor's portfolio stragegy is based not just on a current price divergence but also on their prediction about future sentiment behavior and the speed of convergence of prices.

Publication Research Centre

Institute of Finance and Accounting

Series Number

FIN 480

Series

IFA Working Paper

Available on ECCH

No


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