Sense and Sentiment: A Behavioral Approach to Risk Premium Modelling

Abstract

Estimates of risk premium derived from classical financial theory have consistently shown deviations from the observed levels. These limitations have been linked to the rational foundations of these theories that rely on asset prices as the main source of information. This article focuses on the need to increase the information available through the consideration of behavioral factors.

Therefore, the paper proposes an alternative methodology to estimate risk premium incorporating investor sentiment as a source of additional information.

This model is tested on the US market with the objective of obtaining a more accurate measure of risk premium that the one provided by classical financial approaches. It also offers an alternative explanation to risk-return relationship based on investor’s sentiment. Finally, the use of behavioral approaches to the treatment of the risk premium will favor the control of market anomalies such as the momentum effect.

Keywords: risk premium, sentiment, valuation, beta, momentum

JEL Classification: G40, G12