@article {Lehnert22, author = {Thorsten Lehnert and Yuehao Lin and Nicolas Martelin}, title = {Stein{\textquoteright}s Overreaction Puzzle: Option Anomaly or Perfectly Rational Behavior? }, volume = {23}, number = {3}, pages = {22--35}, year = {2016}, doi = {10.3905/jod.2016.23.3.022}, publisher = {Institutional Investor Journals Umbrella}, abstract = {Among the many anomalies researchers have uncovered in financial markets is Stein{\textquoteright}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{\textquoteright} risk aversion, so that the {\textquotedblleft}overreaction{\textquotedblright} 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{\textquoteright}s results suggest.TOPICS: Options, quantitative methods}, issn = {1074-1240}, URL = {https://jod.pm-research.com/content/23/3/22}, eprint = {https://jod.pm-research.com/content/23/3/22.full.pdf}, journal = {The Journal of Derivatives} }