TY - JOUR
T1 - A rational finance explanation of the stock predictability puzzle
AU - Shirvani, Abootaleb
AU - Rachev, Svetlozar T.
AU - Fabozzi, Frank J.
N1 - Publisher Copyright:
© 2024 University of New Orleans.
PY - 2024/7
Y1 - 2024/7
N2 - We address the stock predictability puzzle, a challenge in the stock market often discussed in behavioral finance. Our approach formulates a statistical model within rational finance, avoiding reliance on behavioral finance assumptions, and integrates stock return predictability into the Black–Scholes option pricing framework. Empirical analysis focuses on the predictability of stock prices by option and spot traders, introducing a forward-looking measure we term “implied excess predictability.” Results show that option traders' predictability of stock returns positively correlates with moneyness, whereas for spot traders, this relationship is inverse. These findings suggest a potential asymmetry in stock price predictability between spot and option traders. Additionally, we demonstrate the importance of incorporating stock return predictability into option pricing formulas, particularly for options with strike prices significantly different from the stock price. Conversely, when moneyness is close to unity, predictability is not integrated into option pricing, indicating equal information among spot and option traders. Comparison of volatility measures reveals the difference between implied and realized variances or variance risk premia as potential predictors of stock returns.
AB - We address the stock predictability puzzle, a challenge in the stock market often discussed in behavioral finance. Our approach formulates a statistical model within rational finance, avoiding reliance on behavioral finance assumptions, and integrates stock return predictability into the Black–Scholes option pricing framework. Empirical analysis focuses on the predictability of stock prices by option and spot traders, introducing a forward-looking measure we term “implied excess predictability.” Results show that option traders' predictability of stock returns positively correlates with moneyness, whereas for spot traders, this relationship is inverse. These findings suggest a potential asymmetry in stock price predictability between spot and option traders. Additionally, we demonstrate the importance of incorporating stock return predictability into option pricing formulas, particularly for options with strike prices significantly different from the stock price. Conversely, when moneyness is close to unity, predictability is not integrated into option pricing, indicating equal information among spot and option traders. Comparison of volatility measures reveals the difference between implied and realized variances or variance risk premia as potential predictors of stock returns.
KW - behavioral finance
KW - option pricing
KW - predictability of stock returns
KW - rational dynamic stock pricing theory
KW - Stratonovich integral
UR - http://www.scopus.com/inward/record.url?scp=85197427626&partnerID=8YFLogxK
U2 - 10.1002/rfe.1210
DO - 10.1002/rfe.1210
M3 - Article
AN - SCOPUS:85197427626
SN - 1058-3300
VL - 42
SP - 316
EP - 327
JO - Review of Financial Economics
JF - Review of Financial Economics
IS - 3
ER -