Unravelling the Asymmetric Volatility Puzzle: A Novel Explanation of Volatility Through Anchoring

TL;DR

This paper offers a behavioral explanation for the asymmetric volatility puzzle, showing how anchoring bias influences investor reactions to price changes, affecting volatility dynamics in financial markets.

Contribution

It introduces a novel behavioral model based on anchoring bias to explain asymmetric volatility, supported by empirical analysis of S&P 500 fluctuations and volatility measures.

Findings

Negative asymmetry between shocks and future volatility confirmed.

Implied volatility is co-integrated with realized volatility but asymmetrically biased.

Medium-term VIX is unbiased but inefficient; short-term VXST is unbiased and efficient.

Abstract

This paper discusses a novel explanation for asymmetric volatility based on the anchoring behavioral pattern. Anchoring as a heuristic bias causes investors focusing on recent price changes and price levels, which two lead to a belief in continuing trend and mean-reversion respectively. The empirical results support our theoretical explanation through an analysis of large price fluctuations in the S&P 500 and the resulting effects on implied and realized volatility. These results indicate that asymmetry (a negative relationship) between shocks and volatility in the subsequent period indeed exists. Moreover, contrary to previous research, our empirical tests also suggest that implied volatility is not simply an upward biased predictor of future deviation compensating for the variance of the volatility but rather, due to investors systematic anchoring to losses and gains in their volatility forecasts, it is a co-integrated yet asymmetric over/under estimated financial instrument. We also provide results indicating that the medium-term implied volatility (measured by the VIX Index) is an unbiased though inefficient estimation of realized volatility, while in contrast, the short-term volatility (measured by the recently introduced VXST Index representing the 9-day implied volatility) is also unbiased and yet efficient.