A Tale of Fear and Euphoria in the Stock Market

Hui Guo, Qian Lin, and Yu-Jou Pai
♦ We propose a consumption-based model to explain the unstable (sometimes positive and sometimes negative) relations between stock market variance with stock market risk premia and prices. In the model, market risk premia depend positively (negatively) on “fear” (“euphoria”) variance. Market prices, which decrease with discount rates, correlate negatively (positively) with fear (euphoria) variance. As the sum of fear and euphoria variances, the market variance may correlate positively or negatively with expected returns and prices, depending on the relative importance of the two variances. Our empirical findings support the model’s key assumptions and many novel implications.

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