Extrapolative Expectations: Implications for Volatility and Liquidity

45 Pages Posted: 19 Mar 2006

Date Written: March 2006

Abstract

This paper presents a model of the joint behavior of liquidity and volatility. In the model, investors extrapolate recent price movements to forecast the volatility of a risky asset. When the perceived volatility is high, the risk premium is high, the current return on the risky asset is low, the risk-free rate is low, and the market is illiquid. Illiquidity amplifies supply shocks thus increasing realized volatility of prices, which in turn, feeds into volatility forecasts for the next period. As a result, clustering of volatility and liquidity arises endogenously even though fundamentals are homoskedastic. The model helps to unify several known facts about liquidity and volatility, and I find support for its new predictions using a measure of misperception of risk based on the implied volatility of options.

Keywords: Liquidity, Volatility, Behavioral Finance, Adaptive Expectations

JEL Classification: G10, G14

Suggested Citation

Deuskar, Prachi, Extrapolative Expectations: Implications for Volatility and Liquidity (March 2006). AFA 2007 Chicago Meetings Paper. Available at SSRN: https://ssrn.com/abstract=891539 or http://dx.doi.org/10.2139/ssrn.891539

Prachi Deuskar (Contact Author)

Indian School of Business ( email )

Hyderabad, Gachibowli 500 019
India

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