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Stein s Overreaction Puzzle: Option Anomaly or Perfectly Rational Behavior?

Author

Listed:
  • Thorsten Lehnert

    ()

  • Yuehao Lin
  • Nicolas Martelin

    (LSF)

Abstract

Empirical studies have shown that implied volatilities of long-term options react quite strongly to changes in implied volatilities of short-term options and do not display the rationally expected smoothing behavior. Given the observed strong mean-reversion in volatility, those findings have been interpreted as evidence for overreaction in the options market. Focusing on a stochastic variance process in a rational expectation framework, we theoretically show that under normal market conditions the risk-neutral volatility dynamics are substantially more persistent than the physical one. As a result, the empirical observation of a strong reaction of longterm volatility would be consistent with perfectly rational behavior. We additionally show that the degree of persistence depends on investors risk aversion. Using daily data on S&P 500 index options, we confirm previous findings for the 2000- 2010 period, which is characterized by an overall moderate level of risk aversion. Once we identify periods of high and low risk aversion, in line with the predictions of our theoretical model, empirical results only hold for periods, when investors are highly risk averse. During periods of low risk aversion, results are insignificant. Robustness checks reveal that the results are remarkably stable over the complete term structure. Therefore, we provide strong evidence that the empirical observation is not overreaction, but in line with perfectly rational behavior.

Suggested Citation

  • 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.
  • Handle: RePEc:crf:wpaper:13-11
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    File URL: http://wwwen.uni.lu/content/download/65842/835392/file/Binder11_SteinsOverreactionPuzzle_OptionAnomalyorPerfectlyRationalBehavior_Lehnert_October2013.pdf
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    References listed on IDEAS

    as
    1. Ait-Sahalia, Yacine & Lo, Andrew W., 2000. "Nonparametric risk management and implied risk aversion," Journal of Econometrics, Elsevier, vol. 94(1-2), pages 9-51.
    2. Lehnert, Thorsten & Lin, Yuehao & Wolff, Christian C, 2013. "Skewness Risk Premium: Theory and Empirical Evidence," CEPR Discussion Papers 9349, C.E.P.R. Discussion Papers.
    3. 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.
    4. Bekkour, Lamia & Jin, Xisong & Lehnert, Thorsten & Rasmouki, Fanou & Wolff, Christian, 2015. "Euro at risk: The impact of member countries' credit risk on the stability of the common currency," Journal of Empirical Finance, Elsevier, vol. 33(C), pages 67-83.
    5. Jackwerth, Jens Carsten, 2000. "Recovering Risk Aversion from Option Prices and Realized Returns," Review of Financial Studies, Society for Financial Studies, vol. 13(2), pages 433-451.
    6. Nicolas P. B. Bollen & Robert E. Whaley, 2004. "Does Net Buying Pressure Affect the Shape of Implied Volatility Functions?," Journal of Finance, American Finance Association, vol. 59(2), pages 711-753, April.
    7. Bakshi, Gurdip & Madan, Dilip & Panayotov, George, 2010. "Deducing the Implications of Jump Models for the Structure of Stock Market Crashes, Rallies, Jump Arrival Rates, and Extremes," Journal of Business & Economic Statistics, American Statistical Association, vol. 28(3), pages 380-396.
    8. Bing Han, 2008. "Investor Sentiment and Option Prices," Review of Financial Studies, Society for Financial Studies, vol. 21(1), pages 387-414, January.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    Option Markets; Overreaction; Rational Expectations; Mean Reversion; Volatility;

    JEL classification:

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

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