Extrapolation and Risk-Return Trade-offs
59 Pages Posted: 8 Mar 2022 Last revised: 13 Apr 2025
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: 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
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