Forecasting volatility with investor pessimism index: Exploring the predictive power of search queries

Abstract

This paper discusses whether investor sentiment contains useful information to predict volatility by constructing investor pessimism index based on Baidu, which is the largest search engine in China. We discover that the investor pessimism index is significantly negatively correlated with contemporaneous returns but predicts following days' returns reversals. Furthermore, the heterogeneous autoregressive model of realized volatility (HAR‐RV) with investor pessimism index performs better than other HAR‐RV‐type benchmark models. We perform a series of robustness tests, which include alternative construction of investor pessimism index, crisis subsample, alternative predictive model, alternative measures of volatility, and considering the role of institutional investor. Our results remain robust. Taken together, investor pessimism index constructed in this paper seem to be a suitable proxy to measure investor sentiment in China and can enhance the accuracy of volatility forecasting in the Chinese stock market.