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Mispricing and the five-factor model under different market sentiments.

En-Te Chen1, Jerry C Ho1

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Summary
This summary is machine-generated.

A two-factor model outperforms the Fama-French five-factor model in high market sentiment periods. The five-factor model is better for low sentiment, showing sentiment impacts asset pricing model choice.

Keywords:
Asset pricingCorporate financeFama and French five factor modelFinanceFinancial marketInternational financeInvestor sentimentMispricingRisk factorsSentiment analysisUMO factorUnderpriced-minus-overpriced

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Area of Science:

  • Finance
  • Asset Pricing
  • Behavioral Finance

Background:

  • Traditional asset pricing models like the Fama-French five-factor model are widely used.
  • Market sentiment is increasingly recognized as a significant factor influencing financial markets.
  • The relative importance of risk versus mispricing in stock returns may vary across different market conditions.

Purpose of the Study:

  • To compare the performance of a two-factor model (market and mispricing factor) against the Fama-French five-factor model.
  • To investigate the impact of market sentiment on the explanatory power of asset pricing models.
  • To determine the optimal asset pricing model under different sentiment regimes.

Main Methods:

  • Utilized a parsimonious two-factor model incorporating the market factor and a mispricing factor (UMO).
  • Compared the performance of this two-factor model against the Fama-French five-factor model.
  • Analyzed asset pricing performance across distinct market sentiment periods (high and low).

Main Results:

  • The two-factor model demonstrated superior performance in explaining average stock returns during high-sentiment periods.
  • The Fama-French five-factor model remained a powerful tool for asset pricing during low-sentiment periods.
  • The study highlights the differential impact of risk and mispricing on stock prices based on market sentiment.

Conclusions:

  • Market sentiment is a crucial variable to consider when selecting an appropriate asset pricing model.
  • A simpler model focusing on market and mispricing factors can be more effective in certain market conditions.
  • The choice of asset pricing model should be dynamic and adapt to prevailing market sentiment regimes.