Misreaction or misspecification? A re-examination of volatility anomalies

Existing research examines the impact of volatility shocks on the relative pricing of long-term vs. short-term options and documents patterns of “short-horizon underreaction” and “long-horizon overreaction” in the options market. These studies, however, rely on implied volatilities derived from specific option-pricing models and are thus subject to model specification errors. In this paper, we show that these anomalous patterns are the result of model misspecification as opposed to market misreaction. We provide evidence that these patterns are consistent with, in both direction and magnitude, inherent biases in the misspecified models. We also apply a model-free approach to re-examine the anomalous patterns and find no evidence of market misreaction.