Extrapolation and Risk-Return Trade-offs

59 Pages Posted: 8 Mar 2022 Last revised: 13 Apr 2025

See all articles by Qi Liu

Qi Liu

Peking University - Department of Finance

Zhiwei Su

Lingnan University

Huijun Wang

Auburn University

Jianfeng Yu

Tsinghua University - PBC School of Finance

Date Written: November 15, 2021

Abstract

This study investigates the impact of return extrapolation on risk-return trade-offs in both the aggregate time series and the cross section. We find that the relation between the market's expected return and expected variance is positive during periods with a low degree of extrapolative weighting (DOX), as proposed by Cassella and Gulen (2018), but turns negative during high-DOX periods. In the cross section, we find that low-risk anomalies are significantly more pronounced following high-DOX periods and among firms with high firm-level DOX. These findings indicate that extrapolation leads to mispricing, thereby undermining the traditional risk-return trade-off.

Keywords: JEL Classification: G11, G12, G40 Behavioral finance, Extrapolation, Risk-return trade-off, Sentiment

JEL Classification: G11, G12, G40

Suggested Citation

Liu, Qi and Su, Zhiwei and Wang, Huijun and Yu, Jianfeng, Extrapolation and Risk-Return Trade-offs (November 15, 2021). PBCSF-NIFR Research Paper Forthcoming, Available at SSRN: https://ssrn.com/abstract=4039296 or http://dx.doi.org/10.2139/ssrn.4039296

Qi Liu

Peking University - Department of Finance ( email )

Beijing
China

Zhiwei Su

Lingnan University ( email )

8 Castle Peak Road
New Territories, Hong Kong
China

Huijun Wang

Auburn University ( email )

415 West Magnolia Avenue
Auburn, AL 36849
United States

Jianfeng Yu (Contact Author)

Tsinghua University - PBC School of Finance ( email )

No. 43, Chengfu Road
Haidian District
Beijing 100083
China

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