Stock Return Extrapolation, Option Prices, and Variance Risk Premium

59 Pages Posted: 2 Feb 2019 Last revised: 24 Sep 2019

See all articles by Adem Atmaz

Adem Atmaz

Purdue University - Krannert School of Management

Date Written: September 23, 2019

Abstract

This paper presents an equilibrium model of stock return extrapolation in the presence of stochastic volatility. In the model, consistent with survey evidence, following negative stock returns, investors expect future returns to be lower but also more volatile. The bias in volatility expectations introduces a new channel through which past stock returns and investor sentiment affect derivative prices. The model is highly tractable and provides analytic option pricing formulas that nest the Heston formulation. The model generates numerous novel predictions and its key implications on option prices and variance risk premium are supported by the empirical evidence.

Keywords: extrapolation, sentiment, stochastic volatility, option prices, variance risk premium, predictability

JEL Classification: G12, G13

Suggested Citation

Atmaz, Adem, Stock Return Extrapolation, Option Prices, and Variance Risk Premium (September 23, 2019). Available at SSRN: https://ssrn.com/abstract=3319502 or http://dx.doi.org/10.2139/ssrn.3319502

Adem Atmaz (Contact Author)

Purdue University - Krannert School of Management ( email )

403 West State Street
West Lafayette, IN 47907
United States

HOME PAGE: http://www.aatmaz.com

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