Investors' beliefs and their implications on asset pricing, excess returns, and volatilities in financial markets

Common aspects of human behavior, like overconfidence or misconceptions in updating beliefs, might influence the market behavior. I extend an existing single-asset overlapping generation model by considering two correlated risky assets for which noise traders may form different beliefs. The theoretical result is consistent with some empirical findings about the asymmetric effect that good/bad news have on market volatility.; The second part is an empirical research. I chose to test the extension's result in industry's stocks. My choice is motivated by the possibility that investors might misinterpret the information that comes into the market and mistakenly believe that relevant information for one firm, is also useful for other firms within the same industry. The testing procedure is to simultaneously estimate excess returns for two groups of industry's stocks. The direct measure for investor sentiment is the Sentiment Index data provided by Investors' Intelligence Service and constructed as a ratio of all the bullish (or bearish) advices divided by the total number of bullish and bearish advices. Empirical results show that investor sentiment is a significant variable in explaining excess returns from industry's stocks. When the second correlated risky asset was introduced as an additional independent variable in the model, the asymmetric effect from positive/negative shifts in sentiment was consistently reduced.; The last chapter is an empirical work that examines the nature of association between noise trader's risk and the implied volatility from option prices. I examined the change in implied volatility each day of the week to see if any unusual change occurred in the day when Sentiment Index was released. The empirical results show that noise traders' actions, driven by their beliefs on non-fundamental information, do affect the option pricing process in a systematic way. Irrational investors acting on noise generate fluctuations in IV from options. This result proves that sentiment is a factor of risk in option pricing also, not only in the stock market pricing process.