Testing the relationship between investor sentiment and asset pricing

Abstract

This paper aims to test whether there exists a type of relationship between investor sentiment and asset pricing. Mainly focusing on using existing asset pricing models such as the Fama and French Three Factor Model (1993), Carhart Four Factor Model (1997), and the Fama and French Five Factor Model (2015), and then adding an investor sentiment factor as an additional variable to each model. This aims to see how this new variable has an effect on the rest of the model, and if a relationship exists between the variables. Two investor sentiment factors are used separately for comparison purposes. This study makes use of correlation matrices, Granger-causality test as well as ARDL Cointegration. These tests are conducted to determine if there is a link between investor sentiment and asset pricing. The general findings suggest that there seems to be little relationship between the variables of the original models with investor sentiment factors, and seems to explain little of the excess return of the portfolios examined. However, despite all this, the altered models all show that there exists a long-run relationship. Therefore, the altered models have a relationship over time, even though the power that the new variables offer to the original models is very low, and does not have a heavy impact on the rest of the models.