Choosing the Right Return Distribution and the Excess Volatility Puzzle

Abootaleb Shirvani and Frank J. Fabozzi

Papers from arXiv.org

Abstract: Proponents of behavioral finance have identified several "puzzles" in the market that are inconsistent with rational finance theory. One such puzzle is the "excess volatility puzzle". Changes in equity prices are too large given changes in the fundamentals that are expected to change equity prices. In this paper, we offer a resolution to the excess volatility puzzle within the context of rational finance. We empirically show that market inefficiency attributable to the volatility of excess return across time is caused by fitting an improper distribution to the historical returns. Our results indicate that the variation of gross excess returns is attributable to poorly fitting the tail of the return distribution and that the puzzle disappears by employing a more appropriate distribution for the return data. The new distribution that we introduce in this paper that better fits the historical return distribution of stocks explains the excess volatility in the market and thereby explains the volatility puzzle. Failing to estimate the historical returns using the proper distribution is only one possible explanation for the existence of the volatility puzzle. However, it offers statistical models within the rational finance framework which can be used without relying on behavioral finance assumptions when searching for an explanation for the volatility puzzle.

Date: 2020-01
New Economics Papers: this item is included in nep-fmk and nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
http://arxiv.org/pdf/2001.08865 Latest version (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:arx:papers:2001.08865

Access Statistics for this paper

More papers in Papers from arXiv.org
Bibliographic data for series maintained by arXiv administrators ().