The paper analyzes the manner in which sentiment affects the pricing kernel. Sentiment
is another term for traders’ errors. The central question of the paper is: How can the
concept of sentiment be formally defined so as to identify the manner in which traders’
errors are manifest in the pricing kernel?

Hersh Shefrin
Mario L. Belotti Professor of Finance
Leavey School of Business
Santa Clara University
Santa Clara, CA 95053

I thank Wayne Ferson, John Campbell, Roni Michaely, Oded Sarig, Simon Benninga, Jacob Boudoukh, Eugene Kandel, Zvi Weiner, Itzhak Venezia, David Hirshleifer, Bhaskaran Swaminathan, Terry Odean, Ming Huang, Peter Carr, Dilip Madan, Frank Milne, Joseph Langsam, Peter Cotton, and Arturo Gonz´alez. I am also grateful to participants at seminars presented at Queen’s University, the University of Michigan, Tel Aviv University, Hebrew University, and Stanford University. Financial support from Santa Clara University and the Dean Witter Foundation is gratefully acknowledged.

Summary:

•Abstract

•Introduction

•Literature Review of Heterogeneity

•The Model

•A Representative Trader Characterization

•SDF and Sentiment

•The Term Structure of Interest Rates

•Risk-neutral Densities and Option Pricing

•Option Pricing Examples

•Mean Variance Returns

•The Market Portfolio

•Contrasting Heterogeneity in Beliefs With Heterogeneity in Risk Tolerance

•Conclusion and Future Directions

•References A-D

•References E-P

•References R-Z

•Appendix