Investor Sentiment and Stock Market Volatility Decomposition

This paper interprets volatility in the stock market as the product of the average correlation and the average variance. Building on this interpretation, this paper constructs a model to account for the impact mechanism of investor sentiment on the market volatility. The empirical findings show that the product of the average correlation and the average variance derived from individual stocks can explain the market volatility well, and thus invalidate the decomposition of the market volatility; investors' high sentiment will exacerbate the market volatility, and the effect on individual stocks volatilities will dominate the market; but meanwhile, high sentiment will weaken the average correlation on the market, which in turn inversely revise the market volatility.