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We are grateful to Wei Xiong for extensive discussions. We are also grateful for comments from Andrew

By Bernard Dumas Alex, Suleyman Basak, Tomas Björk, Andrea Buraschi, Joao Cocco, John Cotter, Xavier Gabaix, Joao Gomes, Tim Johnson, Leonid Kogan, Kostas Koufopoulos, Karen Lewis, Deborah Lucas, Andrew Scott, Alex Stomper, Allan Timmermann, Luis Viceira, Olivier Weill, Hongjun Yan, Amir Yaron, Moto Yogo, Joseph Zechner and Stanley Zin

Abstract

About Excessive Volatility and Sentiment Fluctuations? Our objective is to understand the trading strategy that would allow an investor to take advantage of “excessive ” stock price volatility and “sentiment ” fluctuations. We construct a general equilibrium model of sentiment. In it, there are two classes of agents and stock prices are excessively volatile because one class is overconfident about a public signal. As a result, this class of irrational agents changes its expectations too often, sometimes being excessively optimistic, sometimes being excessively pessimistic. We determine and analyze the trading strategy of the rational investors who are not overconfident about the signal. We find that because irrational traders introduce an additional source of risk, rational investor

Year: 2005
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