Stock Return Extrapolation, Option Prices, and Variance Risk Premium
59 Pages Posted: 2 Feb 2019 Last revised: 24 Sep 2019
Date Written: September 23, 2019
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: Suggested Citation