Price-Path Convexity and Short-Horizon Return Predictability

Abstract

We document a strong negative relation between the curvature of stock price paths (i.e., price-path convexity) and future short-horizon returns at both the aggregate and firm levels. This relation obtains regardless of the cumulative return during the convexity estimation period. At the aggregate level, convexity is a better predictor of future returns than many commonly-used predictors. At the firm level, this effect is not explained by known return predictors, microstructure frictions, or illiquidity. Using survey-based expectations of short-horizon returns, we show that the negative relation between convexity and future returns is driven in part by overextrapolation of past returns. 

Keywords: Price paths, convexity, overextrapolation, short-horizon return predictability

JEL Classification: G02, G12, G14