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A note on Stein’s overreaction puzzle

Author

Listed:
  • Yuehao Lin

    (University of Luxembourg)

  • Thorsten Lehnert

    (University of Luxembourg)

Abstract

Recently, Christoffersen et al. (Rev Financ Stud 26(8):1963–2006, 2013) argue that the overreaction puzzle of Stein (J Finance 44(4):1011–1023, 1989) can be explained by a variance-dependent pricing kernel. In this note, we challenge this view. Our theoretical results are in line with their argument that the variance under risk-neutral measure is more persistent than the variance under physical measure due to a negative variance risk premium. But our results do not support their argument that the more persistent variance is able to qualitatively explain Stein’s findings. We show theoretically that the persistence of the volatility cannot amplify the movements of long-term variance to short-term fluctuations in variance and, therefore, conclude that Stein’s overreaction puzzle is still unsolved.

Suggested Citation

  • Yuehao Lin & Thorsten Lehnert, 2020. "A note on Stein’s overreaction puzzle," Decisions in Economics and Finance, Springer;Associazione per la Matematica, vol. 43(1), pages 269-276, June.
    • Handle: RePEc:spr:decfin:v:43:y:2020:i:1:d:10.1007_s10203-019-00244-z
    DOI: 10.1007/s10203-019-00244-z
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    References listed on IDEAS

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    1. Peter Christoffersen & Steven Heston & Kris Jacobs, 2013. "Capturing Option Anomalies with a Variance-Dependent Pricing Kernel," Review of Financial Studies, Society for Financial Studies, vol. 26(8), pages 1963-2006.
    2. Brennan, M J, 1979. "The Pricing of Contingent Claims in Discrete Time Models," Journal of Finance, American Finance Association, vol. 34(1), pages 53-68, March.
    3. Allen M. Poteshman, 2001. "Underreaction, Overreaction, and Increasing Misreaction to Information in the Options Market," Journal of Finance, American Finance Association, vol. 56(3), pages 851-876, June.
    4. Heston, Steven L, 1993. "A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options," Review of Financial Studies, Society for Financial Studies, vol. 6(2), pages 327-343.
    5. Mark Rubinstein, 1976. "The Valuation of Uncertain Income Streams and the Pricing of Options," Bell Journal of Economics, The RAND Corporation, vol. 7(2), pages 407-425, Autumn.
    6. Thorsten Lehnert & Yuehao Lin & Nicolas Martelin, 2013. "Stein s Overreaction Puzzle: Option Anomaly or Perfectly Rational Behavior?," LSF Research Working Paper Series 13-11, Luxembourg School of Finance, University of Luxembourg.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Pricing kernel; Stochastic volatility; Overreaction; Variance risk;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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