This paper investigates to what extent deviations between market prices of shares and their fundamental values can be explained by risk premium and/or investors sentiment effects. This is done based on recent panel data econometric techniques which can control for the effects of unobserved common factors on our estimation and inference procedures. Our data set consists of share prices listed in the UK stock market, and a very rich set of firm specific and macroeconomic variables, including a variable capturing sentiment effects. To calculate the fundamental values of the shares, the paper relies on book value and earning forecasts of the listed companies, over period 1987-2012. The results of the paper indicate that the deviations between actual (market) share prices and their fundamental values can be explained by both risk premium and sentiment effects. The latter lead to overvaluation of the market share prices, compared to their fundamental values. These results are robust to different estimation methods considered by the paper. The unobserved common factors identified throughout our model, by the panel data estimation techniques, do not add too much to the explanatory power of it, compared to the observed economic variables employed to capture the sentiment and risk premium effects.
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Yiannis Karavias, Stella Spilioti and Elias Tzavalis
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School of EconomicsUniversity of Nottingham
Nottingham, NG7 2RD
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