Sentiment and volatility in the UK stock market

This thesis decomposes the UK market volatility into short- and long-run components using the EGARCH component model and examines the cross-sectional prices of the two components. The empirical results suggest that these two components are significantly priced in the cross-section and the negative risk premia are consistent with the existing literature. However, the ICAPM model in this paper using market excess return and two volatility components as state variables is inferior to the traditional three-factor model. Therefore, investor sentiment is augmented to the EGARCH component model to analyse the impacts of sentiment on market excess return and the components of market volatility. Bullish sentiment leads to higher market excess return while bearish sentiment leads to lower excess return. The sentiment-augmented EGARCH component model compares favourably to the original EGARCH component model which does not take investor sentiment into account. The sentiment-affected volatility components are significantly negatively priced in the cross-section. This paper explores the cross-sectional impacts of market sentiment on stock returns and reveals that the sensitivities of investor sentiment vary monotonically with certain firm characteristics in the cross-section. The analysis suggests that investor sentiments forecast the returns of portfolios that consist of buying stock with high values of a characteristic and selling stock with low values. A sentiment risk factor is constructed to capture the average return differences between stocks most exposed to sentiment and stocks least exposed to sentiment. The two-stage Fama-MacBeth procedure suggests that the sentiment risk factor is significantly priced in the cross-section