Extrapolation and Risk-Return Trade-offs

55 Pages Posted: 8 Mar 2022 Last revised: 24 Feb 2024

See all articles by Qi Liu

Qi Liu

Peking University - Department of Finance

Zhiwei Su

University of Macau

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 of stocks. 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 this relation is 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 are consistent with the interpretation that, relative to a fully rational framework, the existence of extrapolators tends to raise equilibrium stock prices in response to a positive risk shock. The relative increase in stock prices is meant to sustain high perceived future returns to compensate for this enhanced risk for extrapolators and thus leads to overpricing and a weakening of the traditional risk-return trade-off.

Keywords: 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

University of Macau ( email )

Faculty of Business Administration
Macau, 999078
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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