Working Paper: CEPR ID: DP17370
Authors: Xiang Gao; Kees Koedijk; Thomas Walther; Zhan Wang
Abstract: This paper proposed a new metric to gauge investor sentiment using a relative valuation method. We combine investor behavioral traits and option-implied standard deviations under both the real-world probabaility valued most in the view of the uninformed investors and the risk-neutral space adopted when there exists no cognitive error. Given that investor sentiment can be thought of as risk taking by the uniformed exceeding their informed peers, we postulate that the differences between variance, skewness and kurtosis mesures for investors with various behavioral traits.We hence construct our investor sentiment proxy by summing these differentials of variance, skewness and kurtosis in weighted forms. It is documented that such relative investor sentiment metric exhibits economically and statistically strong return predictability for momentum porfolios. Our findings contribute to the extant literature by 1) complementing the Baker-Wurgler market-based investor sentiment index from atheoretical perspective 2) modelling investor sentiment via utilizing the informational content of options prices and 3) supporting the Barberis-Schleifer-Vishny definition of investor sentiment to be differences in financial market participant behavior.
Keywords: sentiment; emotional bias; cognitive error; preservers; accumulators; momentum; return predictability
JEL Codes: G12; G14; G58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Investor sentiment metric (G41) | Predictability of momentum portfolio returns (G17) |
| Differences in variance, skewness, and kurtosis between informed and uninformed investors (G41) | Investor sentiment metric (G41) |
| Investor sentiment metric (G41) | Risk-taking behavior of uninformed investors (G41) |
| Risk-taking behavior of uninformed investors (G41) | Predictability of momentum portfolio returns (G17) |