Abstract
The sustainability of stock price fluctuations indicated by many empirical studies hardly reconciles with the existing models in standard financial theories. This paper proposes a recursive dynamic asset pricing model based on the comprehensive impact of the sentiment investor, the information trader and the noise trader. The dynamic process of the asset price is characterized and a numerical simulation of the model is provided. The model captures the features of the actual stock price that are consistent with the empirical evidence on the sustainability of stock price fluctuations. It also offers a partial explanation for other financial anomalies, for example, asset price’s overreaction, asset bubble and the financial crisis. The major finding is that investor sentiment is the key factor to understand the sustainability of stock price fluctuations.
Highlights
Stock price fluctuations are always higher than the expectation of the standard financial theory
We show that overreaction, asset bubble and the financial crisis are attributable to investor sentiment
Denote that S0 is the initial value of the stock, εi is a piece of positive information appearing at the time i; Pt is the stock price at the time t; θQ is the effect of noise trader on stock price and θ is a coefficient that varies with the risk aversion of the noise trader
Summary
Stock price fluctuations are always higher than the expectation of the standard financial theory. Aforementioned empirical papers show that stock price fluctuations by the combined action of the rational investor (the information trader) and the sentiment investor, instead of heterogeneous sentiment investors. These phenomena indicate a gap between current theoretical models and empirical evidence. To fill the gap between the asset pricing theory model and empirical model in the paper, a recursive dynamic asset pricing model with heterogeneous traders (the information trader, the sentiment trader and the noise trader) is proposed to explain in theory why the sustainability of stock price fluctuations appears in the real financial market.
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