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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 Citation[1978] 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.
Notes
1. The details of the derivation please see Shu Citation[2010], and the time interval is set to be one year.
2. This analysis uses the parameter values u = 0.018 and = 0.035 obtained by Mehra and Sah Citation[2002]. Mehra and Sah got the parameter values from data on U.S. per capita real consumption of nondurables and services.