Investor Sentiment and Financial Market Volatility

Abstract

Empirical studies have documented the influence of investor sentiment on financial markets, but the underlying economic mechanism remains unclear. This study links psychological research and a traditional asset-pricing model to investigate the influence of investor sentiment variations on financial markets. By relaxing the assumption of investor rationality, this investigation shows that a modified Lucas [1978] Lucas, R. E. “Asset Prices in an Exchange Economy.” Econometrica, 46, (1978), pp. 1429–1445.[Crossref], [Web of Science ®] , [Google Scholar] model can adequately interpret prominent financial market anomalies, such as high volatility, bubble and crash formation, and the relationships among investor sentiment, asset prices and expected returns.

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