Market Sentiment and the Sharpe Ratio: A Prospect Theory Approach

36 Pages Posted: 16 Mar 2020 Last revised: 13 Jul 2020

See all articles by Soroush Ghazi

Soroush Ghazi

University of Alabama - Department of Economics, Finance and Legal Studies

Mark Schneider

University of Alabama - Department of Economics, Finance and Legal Studies

Date Written: February 21, 2020

Abstract

Market sentiment drives fluctuations in financial markets, but it is measured with empirical proxies lacking strong theoretical foundations. In a generalization of the Consumption CAPM where the representative agent has a prospect theory probability weighting function, we derive a formula for market sentiment that is approximately a decreasing linear function of the conditional market Sharpe ratio, a sufficient statistic for market performance. Our derived sentiment index is negatively correlated with the realized Sharpe ratio, and positively correlated with empirical sentiment indexes. The components of the conditional Sharpe ratio are sufficient to isolate the systematic components of empirical sentiment indexes.

Keywords: Prospect Theory; EU-Hurwicz Preferences; Sharpe Ratio; Equity Premium; Sentiment Indexes

JEL Classification: G40, G41

Suggested Citation

Ghazi, Soroush and Schneider, Mark, Market Sentiment and the Sharpe Ratio: A Prospect Theory Approach (February 21, 2020). Available at SSRN: https://ssrn.com/abstract=3541473 or http://dx.doi.org/10.2139/ssrn.3541473

Soroush Ghazi (Contact Author)

University of Alabama - Department of Economics, Finance and Legal Studies ( email )

P.O. Box 870244
Tuscaloosa, AL 35487
United States

HOME PAGE: http://sites.google.com/view/soroush-ghazi

Mark Schneider

University of Alabama - Department of Economics, Finance and Legal Studies ( email )

361 Stadium Dr, Ste 200
Tuscaloosa, AL 35487
United States

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