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

  • BERNARD DUMAS
  • ALEXANDER KURSHEV
  • RAMAN UPPAL

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 optimizing intertemporally. Overconfident investors overreact to the signal and introduce an additional risk factor causing stock prices to be excessively volatile. Consequently, rational investors choose a conservative portfolio; moreover, this portfolio depends not just on the current price divergence but also on their prediction about future sentiment and the speed of price convergence. Copyright (c) 2009 the American Finance Association.

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File URL: http://www.blackwell-synergy.com/doi/abs/10.1111/j.1540-6261.2009.01444.x
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Article provided by American Finance Association in its journal The Journal of Finance.

Volume (Year): 64 (2009)
Issue (Month): 2 (04)
Pages: 579-629

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Handle: RePEc:bla:jfinan:v:64:y:2009:i:2:p:579-629
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