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Stein’s Overreaction Puzzle: Option Anomaly or Perfectly Rational Behavior?

Thorsten Lehnert, Yuehao Lin and Nicolas Martelin
The Journal of Derivatives Spring 2016, 23 (3) 22-35; DOI: https://doi.org/10.3905/jod.2016.23.3.022
Thorsten Lehnert
is professor at the Luxembourg School of Finance at the University of Luxembourg in Luxembourg.
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Yuehao Lin
is a PhD candidate at the Luxembourg School of Finance at the University of Luxembourg in Luxembourg.
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  • For correspondence: yuehao.lin@uni.lu
Nicolas Martelin
is a PhD candidate at the Luxembourg School of Finance at the University of Luxembourg in Luxembourg.
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  • For correspondence: nicolas.martelin@uni.lu
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Abstract

Among the many anomalies researchers have uncovered in financial markets is Stein’s finding that implied volatilities (IVs) from long-term options are too sensitive to short-shortrun volatility shocks. Option investors overreact to a spike in implied volatility for nearby contracts, and volatilities rise across the maturity spectrum, in contradiction to the smoothing effect when a mean-reverting time series is averaged over a long period. Lehnert, Lin, and Martelin have found a plausible explanation in the fact that mean-reversion of volatility estimated from stock returns is an empirical estimate, while implied volatilities are risk-neutralized values. They show that risk-neutral mean reversion is much slower than in the empirical process. Moreover, it depends on investors’ risk aversion, so that the “overreaction” effect caused by sluggish reversion toward long-run average volatility should be greatest when investors are most averse to risk. They then demonstrate that the theoretical argument is supported by the data. Long-maturity options show significant overreaction to short-maturity IV changes, but the effect is much stronger during periods of market upset. The options market appears to be more rational than Stein’s results suggest.

TOPICS: Options, quantitative methods

  • © 2016 Pageant Media Ltd
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The Journal of Derivatives: 23 (3)
The Journal of Derivatives
Vol. 23, Issue 3
Spring 2016
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Stein’s Overreaction Puzzle: Option Anomaly or Perfectly Rational Behavior?
Thorsten Lehnert, Yuehao Lin, Nicolas Martelin
The Journal of Derivatives Feb 2016, 23 (3) 22-35; DOI: 10.3905/jod.2016.23.3.022

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Stein’s Overreaction Puzzle: Option Anomaly or Perfectly Rational Behavior?
Thorsten Lehnert, Yuehao Lin, Nicolas Martelin
The Journal of Derivatives Feb 2016, 23 (3) 22-35; DOI: 10.3905/jod.2016.23.3.022
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