Misreaction or Misspecification? A Re-Examination of Volatility Anomalies
12 Pages Posted: 22 Aug 2011 Last revised: 20 Feb 2013
Date Written: February 16, 2010
Existing research examines the impact of volatility shocks on the relative pricing of long-term vs. short-term options and documents patterns of short-horizon underreaction and long-horizon overreaction in the options market. These studies, however, rely on implied volatilities derived from specific option pricing models and are thus subject to model specification errors. In this paper, we show that these anomalous patterns are the result of model misspecification as opposed to market misreaction. We provide evidence that these patterns are consistent with, in both direction and magnitude, inherent biases in the misspecified models. We also apply a model-free approach to re-examine the anomalous patterns and find no evidence of market misreaction.
Keywords: Volatility anomaly, Model misspecification, Market misreaction, Model-free implied volatility, Market efficiency
JEL Classification: G13, G14
Suggested Citation: Suggested Citation