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

Author

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  • 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?," DEM Discussion Paper Series 13-11, Department of Economics at the University of Luxembourg.
  • Handle: RePEc:luc:wpaper:13-11
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    Cited by:

    1. Harun Onder & Pierre Pestieau & Grégory Ponthière, 2019. "Equivalent income versus equivalent lifetime: does the metric matter?," Working Papers halshs-02187803, HAL.
    2. Matteo Picchio & Giacomo Valletta, 2018. "A welfare evaluation of the 1986 tax reform for married couples in the United States," International Tax and Public Finance, Springer;International Institute of Public Finance, vol. 25(3), pages 757-807, June.
    3. Marc Fleurbaey & Gregory Ponthiere, 2023. "Measuring well-being and lives worth living," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 75(4), pages 1247-1266, May.
    4. Alpaslan Akay & Olivier Bargain & H. Xavier Jara, 2020. "‘Fair’ welfare comparisons with heterogeneous tastes: subjective versus revealed preferences," Social Choice and Welfare, Springer;The Society for Social Choice and Welfare, vol. 55(1), pages 51-84, June.
    5. Olivier Bargain, 2017. "Welfare analysis and redistributive policies," The Journal of Economic Inequality, Springer;Society for the Study of Economic Inequality, vol. 15(4), pages 393-419, December.
    6. Bart Capéau & Liebrecht De Sadeleer & Sebastiaan Maes & André Decoster, 2020. "Nonparametric welfare analysis for discrete choice: levels and differences of individual and social welfare," Working Papers of Department of Economics, Leuven 674666, KU Leuven, Faculty of Economics and Business (FEB), Department of Economics, Leuven.
    7. Bart Capéau & André Decoster & Stijn Van Houtven, 2024. "Piecemeal Modeling of the Effects of Joint Direct and Indirect Tax Reforms," Public Finance Review, , vol. 52(1), pages 111-149, January.

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    More about this item

    Keywords

    Option Markets; Overreaction; Rational Expectations; Mean Reversion; Volatility;
    All these keywords.

    JEL classification:

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

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