Sentiment and Speculation in a Market with Heterogeneous Beliefs: Ian Martin (LSE)

Abstract: We present a model featuring risk-averse investors with heterogeneous beliefs. Individuals who are correct in hindsight, whether through luck or judgment, become relatively wealthy. As a result, market sentiment is bullish following good news and bearish following bad news. Sentiment drives up volatility, and hence also risk premia. In a continuous-time Brownian limit, moderate investors trade against market sentiment in the hope of capturing a variance risk premium created by the presence of extremists. In a Poisson limit that features sudden arrivals of information, CDS rates spike following bad news and decline during quiet times.

Please contact Britta Augsberg britta_a@ifs.org.uk for the seminar link and password.