Sentiment approach to underestimation and overestimation pricing model

a r t i c l e i n f o Based on the underestimation model in bear markets and the overestimation model in bull markets, we propose two types of sentiment asset pricing models to study the effects of investor sentiment on stock prices and limit of arbitrage. The two sentiment asset pricing models demonstrate that investor sentiment has a systematic and significant impact on stock prices; furthermore, investor sentiment plays a significant role on the limit of arbitrage. We find that our framework can be helpful in understanding a range of financial anomalies: overreaction, underreaction, the fire sales and the limit of arbitrage. Whether on earth investor sentiment drives the changes of stock prices is a worthy question. Especially, a broad set of anomalies in the stock market strengthen doubts about the traditional financial theory and enhance the interest in investor sentiment in recent years. Many empirical studies have documented evidence of investor sentiment effects in asset prices (Lee et al. reveal that investor sentiment affects smaller stock returns and leads to mispricing. Loewenstein (2000) demonstrates that the existence and importance of investor sentiment is correct, and investor sentiment affects the stock valuation. Brown and Cliff (2004) shed light on the effects of sentiment on market valuation and stock returns. Baker and Wurgler (2006, 2007) explain that stocks are likely to be most affected by sentiment and predict that investor sentiment has greater effects on stocks whose valuations are highly subjective and hard to arbitrage. In general, investor sentiment has an important impact on stock prices. In particular, this paper investigates the effects of investor sentiment on stock prices and limit of arbitrage, and further explains underreaction, overreaction and fire sales. Many literatures prove that financial markets and financial industry are sentiment-driven domains, their interactions mainly occur at the investors' cognitive value and their available information. The key for making optimal investment decisions depends on available information and investor sentiment. De Long et al. (1990) explain that arbitrageurs observe fundamental value, so their demands are simple functions of the difference between fundamental value and price. Barberis et al. (1998) illustrate that investor's beliefs are reflecting the 'consensus', even if different investors have different beliefs and proved that cogni-tive biases are sufficient to simultaneously deliver both short-horizon continuation and long-horizon reversals. Daniel et al. (1998) also prove that cognitive biases are sufficient to simultaneously deliver both short-horizon continuation and …