Investor Sentiment and Volume-Volatility Relationship∗

This paper shows the effect of investor sentiment on information processing in the financial market. We investigate how disagreement among investors affects the relationship between trading intensity and price volatility around macroeconomic announcements during high and low sentiment periods. By incorporating into the Kandel and Pearson (1995) model a one factor structure with heterogeneous beliefs in the idiosyncratic components, we explicitly derive the volume-volatility elasticity for individual stocks around systematic information release. Our empirical results are based on intraday transaction data of S&P 500 ETF and Dow Jones 30 components, as well as high frequency econometric tools for the multi-dimensional setting. Consistent with the model predictions, our estimates of elasticity decrease significantly with the ratio of idiosyncratic variance. Disagreement measures only cast significantly negative effect in high sentiment periods for both the market portfolio and individual stocks, which is in line with changes in investors’ confidence level when sentiment regime shifts.