Overreactions in the options markets in Japan

Abstract

This study investigates the ‘term structure’ of implied volatilities of the NIKKEI 225 index options in order to examine the existence of investors' overreaction in the options markets in Japan. According to the rational expectations theory, the implied volatility on a longer maturity option should move by less than 1% in response to a 1% move in the implied volatility of a shorter maturity option. However, the empirical analyses show that this elasticity turns out to be larger than suggested by the theory. These results from Japanese markets, indicating that long-maturity options tend to ‘overreact’ to the new information in comparison with the short-maturity options, are similar to those found in the USA.

Acknowledgements

We particularly thank Professor Mark Taylor, the Editor, for providing us with helpful advice in refining this paper. We are also grateful to two anonymous referees, and to the Japan Society for the Promotion of Science and the Japan Securities Scholarship Foundation for their generous financial assistance to this research.

Notes

¹ Tversky and Kahneman (1974) provide the experimental evidence that people have a systematic tendency to overemphasize recent data when making projections.

² Diacogiannis et al. (2005) confirm the occurrence of short-term overreactions on the Athens Stock Exchange. Galariotis (2004) finds that the overreaction to the firm-specific return component largely contributes to the contrarian profits in the Athens Stock Exchange. Benzion et al. (2004) investigate the exponential-function misevaluation as a subjective discount function, and suggest that their findings of misevaluation are indirectly influenced by the overconfidence and overreaction phenomena. In addition, Wang et al. (2004) find that, in China, the overreaction effect is more pronounced in the market for domestically-owned A shares than in the market for foreign-owned B shares. Furthermore, Vergin (2001) points out that the overreaction bias in the National Football League betting market provides another example of a violation of the weak form of the Efficient Markets Hypothesis.

³ This follows the treatment by, for example, Poteshman (2001), and Ait-Sahalia and Lo (1998).

⁴ This follows Stein (1989) and Poteshman (2001).

⁵ Namely, n-week autocorrelation is converted to an implied weekly ρ by raising it to the one-nth power.

⁶ For example, see Campbell and Shiller (1984) and Froot (1989).