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Price discovery and sentiment

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  • Jacoby, Gady
  • Liao, Rose C.

Abstract

This paper investigates the influence of sentimental noise traders on the security price adjustment. We use De Long et al.'s (1990) definition of noise traders, who falsely believe they have special information, to extend Easley and O'Hara's (1992) seminal model. Our extended model demonstrates the existence of noise traders in the market narrows bid-ask spreads and slows down the speed of price reversion to the fundamental value. Furthermore, the bid-ask spread widens when noise trader sentiment aligns with the market maker's prior beliefs. We show that the market maker's ability to accurately predict noise traders' sentiment is positively related to the quoted bid-ask spread and to the speed of price reversion. We demonstrate that Easley and O'Hara's model is a special case of our model. Their conclusion that time is a factor in the security price adjustment process is strengthened in the presence of the erroneous sentiment of noise traders.

Suggested Citation

  • Jacoby, Gady & Liao, Rose C., 2012. "Price discovery and sentiment," International Review of Financial Analysis, Elsevier, vol. 21(C), pages 108-118.
    • Handle: RePEc:eee:finana:v:21:y:2012:i:c:p:108-118
    DOI: 10.1016/j.irfa.2011.09.005
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    References listed on IDEAS

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    1. Malcolm Baker & Jeffrey Wurgler, 2006. "Investor Sentiment and the Cross‐Section of Stock Returns," Journal of Finance, American Finance Association, vol. 61(4), pages 1645-1680, August.
    2. Chen, Jeng-Hong & Jiang, Christine X. & Kim, Jang-Chul & McInish, Thomas H., 2003. "Bid-Ask Spreads, Information Asymmetry, and Abnormal Investor Sentiment: Evidence from Closed-End Funds," Review of Quantitative Finance and Accounting, Springer, vol. 21(4), pages 303-321, December.
    3. De Long, J Bradford & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1990. "Noise Trader Risk in Financial Markets," Journal of Political Economy, University of Chicago Press, vol. 98(4), pages 703-738, August.
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    Citations

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    Cited by:

    1. Bahloul, Walid & Bouri, Abdelfettah, 2016. "The impact of investor sentiment on returns and conditional volatility in U.S. futures markets," Journal of Multinational Financial Management, Elsevier, vol. 36(C), pages 89-102.
    2. Xu, Shaojun, 2023. "Behavioral asset pricing under expected feedback mode," International Review of Financial Analysis, Elsevier, vol. 86(C).
    3. Fu, Chengbo & Jacoby, Gady & Wang, Yan, 2015. "Investor sentiment and portfolio selection," Finance Research Letters, Elsevier, vol. 15(C), pages 266-273.
    4. Bahloul, Walid & Bouri, Abdelfettah, 2016. "Profitability of return and sentiment-based investment strategies in US futures markets," Research in International Business and Finance, Elsevier, vol. 36(C), pages 254-270.
    5. Pedro Piccoli & Newton C. A. da Costa & Wesley Vieira da Silva & June A. W. Cruz, 2018. "Investor sentiment and the risk–return tradeoff in the Brazilian market," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 58(S1), pages 599-618, November.
    6. Sobti, Neharika & Sehgal, Sanjay & Ilango, Balakrishnan, 2021. "How do macroeconomic news surprises affect round-the-clock price discovery of gold?," International Review of Financial Analysis, Elsevier, vol. 78(C).

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    More about this item

    Keywords

    Market microstructure; Noise traders; Investor sentiment; Bid-ask spread;
    All these keywords.

    JEL classification:

    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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