Hostname: page-component-7dd5485656-npwhs Total loading time: 0 Render date: 2025-10-21T06:04:19.783Z Has data issue: false hasContentIssue false
  • English
  • Français

Return Extrapolation and Volatility Expectations

Published online by Cambridge University Press:  28 March 2025

Tarun Chordia ,
Tse-Chun Lin Open the ORCID record for Tse-Chun Lin [Opens in a new window]  and
Vincent Xiang
Tarun Chordia
Affiliation:
Emory University Goizueta Business School Tarun.Chordia@emory.edu
Tse-Chun Lin*
Affiliation:
Zhejiang University The School of Economics and The University of Hong Kong Faculty of Business and Economics
Vincent Xiang
Affiliation:
Deakin University Department of Finance, Faculty of Business and Law v.xiang@deakin.edu.au
*
tsechunlin@hku.hk (corresponding author)
Rights & Permissions [Opens in a new window]

Abstract

Core share and HTML view are not available for this content. However, as you have access to this content, a full PDF is available via the ‘Save PDF’ action button.

This article provides the first comprehensive evidence that the return extrapolation behavior of investors leads to biases in the expectations of volatility. Lower past returns are associated with higher expectations of volatility when using the physical, risk-neutral, and survey measures to estimate volatility expectations. Consistent with the return extrapolation framework, recent past returns have a larger impact than distant past returns on volatility expectations. Biases in volatility expectations are i) distinct from extrapolating past realized volatility, ii) asymmetrically induced by recent past negative returns, and iii) lead investors to pay more to insure against the perceived higher expected volatility.

Information

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , First View , pp. 1 - 39
Creative Commons
Creative Common License - CCCreative Common License - BY
This is an Open Access article, distributed under the terms of the Creative Commons Attribution licence (http://creativecommons.org/licenses/by/4.0), which permits unrestricted re-use, distribution and reproduction, provided the original article is properly cited.
Copyright
© The Author(s), 2025. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

Footnotes

We thank Thierry Foucault (the editor) and an anonymous referee. We also thank Adem Atmaz, Hui Chen, and seminar participants at the 2022 FIRN conference, Monash University, University of Technology of Sydney, University of Adelaide, Deakin University, La Trobe University, and University of Otago for helpful comments. All remaining errors are our own.

References

Alti, A., and Tetlock, P. C.. “Biased Beliefs, Asset Prices, and Investment: A Structural Approach.” Journal of Finance, 69 (2014), 325–361.10.1111/jofi.12089CrossRefGoogle Scholar
Amromin, G., and Sharpe, S.. “From the Horse’s Mouth: Economic Conditions and Investor Expectations of Risk and Return.” Management Science, 60 (2014), 845–866.CrossRefGoogle Scholar
Andersen, T. G.; Bollerslev, T.; Diebold, F. X.; and Evens, H.. “The Distribution of Realized Stock Return Volatility.” Journal of Financial Economics, 61 (2001), 43–76.CrossRefGoogle Scholar
Atmaz, A. “Stock Return Extrapolation, Option Prices, and Variance Risk Premium.” Review of Financial Studies, 35 (2022), 1348–1393.CrossRefGoogle Scholar
Bakshi, G.; Kapadia, N.; and Madan, D.. “Stock Return Characteristics, Skew Laws, and the Differential Pricing of Individual Equity Options.” Review of Financial Studies, 16 (2003), 101–143.10.1093/rfs/16.1.0101CrossRefGoogle Scholar
Baltussen, G.; van Bekkum, S.; and van der Grient, B.. “Unknown Unknowns: Uncertainty About Risk and Stock Returns.” Journal of Financial and Quantitative Analysis, 53 (2018), 1615–1651.10.1017/S0022109018000480CrossRefGoogle Scholar
Barberis, N.; Greenwood, R.; Jin, L.; and Shleifer, A.. “X-CAPM: An Extrapolative Capital Asset Pricing Model.” Journal of Financial Economics, 115 (2015), 1–24.10.1016/j.jfineco.2014.08.007CrossRefGoogle Scholar
Barberis, N.; Greenwood, R.; Jin, L.; and Shleifer, A.. “Extrapolation and Bubbles.” Journal of Financial Economics, 129 (2018), 203–227.10.1016/j.jfineco.2018.04.007CrossRefGoogle Scholar
Barberis, N., and Huang, M.. “Mental Accounting, Loss Aversion, and Individual Stock Returns.” Journal of Finance, 56 (2001), 1247–1292.10.1111/0022-1082.00367CrossRefGoogle Scholar
Beutel, J., and Weber, M.. “Beliefs and Portfolios: Causal Evidence.” Chicago Booth Research Paper No.22-08 (2022).10.1257/rct.9576-1.0CrossRefGoogle Scholar
Bollen, N. P. B., and Whaley, R. E.. “Does Net Buying Pressure Affect the Shape of Implied Volatility Functions?” Journal of Finance, 59 (2004), 711–753.10.1111/j.1540-6261.2004.00647.xCrossRefGoogle Scholar
Bollerslev, T.; Tauchen, G.; and Zhou, H.. “Expected Stock Returns and Variance Risk Premia.” Review of Financial Studies, 22 (2009), 4463–4492.10.1093/rfs/hhp008CrossRefGoogle Scholar
Brunnermeier, M.; Farhi, E.; Koijen, R. S. J.; Krishnamurthy, A.; Ludvigson, S. C.; Lustig, H.; Nagel, S.; and Piazzesi, M.. “Review Article: Perspectives on the Future of Asset Pricing.” Review of Financial Studies, 34 (2021), 2126–2160.10.1093/rfs/hhaa129CrossRefGoogle Scholar
Carr, P., and Wu, L.. “Variance Risk Premiums.” Review of Financial Studies, 22 (2009), 1311–1341.10.1093/rfs/hhn038CrossRefGoogle Scholar
Cassella, S.; Chen, Z. J.; Gulen, H.; and Pekova, R.. “Extrapolators at the Gate: Market-Wide Misvaluation and the Value Premium.” Working Paper, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3705481 (2022).Google Scholar
Cassella, S., and Gulen, H.. “Extrapolation Bias and the Predictability of Stock Returns by Price-Scaled Variables.” Review of Financial Studies, 31 (2018), 4345–4397.10.1093/rfs/hhx139CrossRefGoogle Scholar
Chen, T-F.; Chordia, T.; Chung, S-L.; and Lin, J-C.. “Volatility-of-Volatility Risk in Asset Pricing.” Review of Asset Pricing Studies, 12 (2022), 289–335.10.1093/rapstu/raab018CrossRefGoogle Scholar
Cheng, I.-H. “The VIX Premium.” Review of Financial Studies, 32 (2019), 180–227.10.1093/rfs/hhy062CrossRefGoogle Scholar
Choi, J., and Mertens, T.. “Extrapolative Expectations and the Equity Premium.” Working Paper, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3462056 (2019).10.2139/ssrn.3462056CrossRefGoogle Scholar
Corsi, F. “A Simple Approximate Long-Memory Model of Realized Volatility.” Journal of Financial Econometrics, 7 (2009), 174–196.10.1093/jjfinec/nbp001CrossRefGoogle Scholar
Da, Z.; Gurun, U. G.; and Warachka, M.. “Frog in the Pan: Continuous Information and Momentum.” Review of Financial Studies, 27 (2014), 2171–2218.CrossRefGoogle Scholar
Da, Z.; Huang, X.; and Jin, L. J.. “Extrapolative Beliefs in the Cross-Section: What Can We Learn from the Crowds?” Journal of Financial Economics, 140 (2021), 175–196.10.1016/j.jfineco.2020.10.003CrossRefGoogle Scholar
Drechsler, I., and Yaron, A.. “What’s Vol Got to Do with It.” Review of Financial Studies, 24 (2011), 1–45.10.1093/rfs/hhq085CrossRefGoogle Scholar
Egan, M.; MacKay, A.; and Yang, H.. “What Drives Variation in Investor Portfolios? Evidence from Retirement Plans.” NBER Working Paper No. 29604 (2022).10.2139/ssrn.3988281CrossRefGoogle Scholar
Engelberg, J.; McLean, R. D.; and Pontiff, J.. “Anomalies and News.” Journal of Finance, 73 (2018), 1971–2001.10.1111/jofi.12718CrossRefGoogle Scholar
Frydman, C., and Nave, G.. “Extrapolative Beliefs in Perceptual and Economic Decisions: Evidence of a Common Mechanism.” Management Science, 63 (2017), 2340–2395.10.1287/mnsc.2016.2453CrossRefGoogle Scholar
Gârleanu, N.; Pedersen, L. H.; and Poteshman, A. M.. “Demand-Based Option Pricing.” Review of Financial Studies, 22 (2009), 4259–4299.10.1093/rfs/hhp005CrossRefGoogle Scholar
Ghysels, E.; Santa-Clara, P.; and Valkanov, R.. “Predicting Volatility: Getting the Most out of Return Data Sampled at Different Frequencies.” Journal of Econometrics, (2006), 59–95.10.1016/j.jeconom.2005.01.004CrossRefGoogle Scholar
Giglio, S., and Kelly, B.. “Excess Volatility: Beyond Discount Rates.” Quarterly Journal of Economics, 133 (2018), 71–127.10.1093/qje/qjx034CrossRefGoogle Scholar
Glaeser, E. L., and Nathanson, C. G.. “An Extrapolative Model of House Price Dynamics.” Journal of Financial Economics, 126 (2017), 147–170.CrossRefGoogle Scholar
Goyal, A., and Saretto, A.. “Cross-Section of Option Returns and Volatility.” Journal of Financial Economics, (2009), 310–326.10.1016/j.jfineco.2009.01.001CrossRefGoogle Scholar
Greenwood, R., and Shleifer, A.. “Expectations of Returns and Expected Returns.” Review of Financial Studies, 27 (2014), 714–746.CrossRefGoogle Scholar
Han, B. “Investor Sentiment and Option Prices.” Review of Financial Studies, 21 (2008), 387–414.10.1093/rfs/hhm071CrossRefGoogle Scholar
Hartzmark, S. M.; Hirshman, S. D.; and Imas, A.. “Ownership, Learning, and Beliefs.” Quarterly Journal of Economics, 136 (2021), 1665–1717.10.1093/qje/qjab010CrossRefGoogle Scholar
Hirshleifer, D.; Li, J.; and Yu, J.. “Asset Pricing in Production Economies with Extrapolative Expectations.” Journal of Monetary Economics, 76 (2015), 87–106.10.1016/j.jmoneco.2015.08.006CrossRefGoogle Scholar
Jackwerth, J., and Grigory, V.. “Asymmetric Volatility Risk: Evidence from Option Markets.” Review of Finance, 23 (2019), 777–799.10.1093/rof/rfy025CrossRefGoogle Scholar
Jin, L. J., and Sui, P.. “Asset Pricing with Return Extrapolation.” Journal of Financial Economics, 145 (2022), 273–295.10.1016/j.jfineco.2021.10.009CrossRefGoogle Scholar
Kahneman, D., and Tversky, A.. “Prospect Theory: An Analysis of Decision Under Risk.” Econometrica, 47 (1979), 263–292.10.2307/1914185CrossRefGoogle Scholar
Kaplanski, G.; Levy, H.; Veld, C.; and Veld-Merkoulova, Y.. “Past Returns and the Perceived Sharpe Ratio.” Journal of Economic Behavior and Organization, 123 (2016), 149–167.10.1016/j.jebo.2015.11.010CrossRefGoogle Scholar
Kuchler, T., and Zafar, B.. “Personal Experiences and Expectations About Aggregate Outcomes.” Journal of Finance, 74 (2019), 2491–2542.10.1111/jofi.12819CrossRefGoogle Scholar
Li, K., and Liu, J.. “Extrapolative Asset Pricing.” Journal of Economic Theory, 210 (2023), 105651.10.1016/j.jet.2023.105651CrossRefGoogle Scholar
Lochstoer, L. A., and Muir, T.. “Volatility Expectations and Returns.” Journal of Finance, 77 (2022), 1055–1096.CrossRefGoogle Scholar
Muravyev, D., and Pearson, N. D.. “Options Trading Costs Are Lower than You Think.” Review of Financial Studies, 33 (2020), 4973–5014.CrossRefGoogle Scholar
Nagel, S., and Xu, Z.. “Dynamics of Subjective Risk Premia.” Journal of Financial Economics, 150 (2023), 103713.10.1016/j.jfineco.2023.103713CrossRefGoogle Scholar
Pénasse, J., and Renneboog, L.. “Speculative Trading and Bubbles: Evidence from the Art Market.” Management Science, 68 (2022), 4939–4963.10.1287/mnsc.2021.4088CrossRefGoogle Scholar
Pyun, S. “Variance Risk in Aggregate Stock Returns and Time-Varying Return Predictability.” Journal of Financial Economics, 132 (2019), 150–174.10.1016/j.jfineco.2018.10.002CrossRefGoogle Scholar
Supplementary material: File

Chordia et al. supplementary material

Chordia et al. supplementary material
Download Chordia et al. supplementary material(File)
File 252 KB