Investor Sentiment, Extrapolation and Asset Pricing

We develop an asset pricing model with investor sentiment and extrapolative behavior by assuming that there are many investors in the market who form their stock demand by weighting the sentiment signal, the extrapolative signal and the value signal. Our model predicts that both investor sentiment and extrapolation impose positive effects on the stock price deviation from fundamental value, and the direction and magnitude of stock price deviation depend on the relative strength of the sentiment signal and the extrapolation signal. Futhermore, we find that the weights of the sentiment signal and the extrapolative signal are positively related to the short-term correlation of stock returns, while the lagged weight of sentiment signal negatively effects the short-term correlation of stock returns. Moreover, the model also predicts that the sentiment signal and extrapolative signal weights are positively correlated with stock volatility, and extrapolative behavior exacerbates the sentiment-driven stock volatility due to extrapolating endogenous stock returns. Finally, we find empirical evidence consistent with the model’s predictions.