Market Sentiment and the Sharpe Ratio: A Prospect Theory Approach
36 Pages Posted: 16 Mar 2020 Last revised: 13 Jul 2020
Date Written: February 21, 2020
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: Suggested Citation