The Waterfall Illusion, and How Exposure to Extreme Volatility Distorts Risk Perceptions in Markets
Year: 2016
Type: preprint
Abstract: Prolonged exposure to extremes of a variable inversely biases subsequent perceptions of that variable; an effect known as the “waterfall illusion” or “after-effect”. We present the first evidence that after-effects bias investors’ perceptions of volatility, resulting in significant distortions of prices in a sophisticated and liquid market. We find that after prolonged exposure to high (low) volatility, the marginal trader under- (over-) estimates volatility. The longer the exposure and the stronger the volatility level, the larger the subsequent bias. Additional tests rule out the most plausible competing explanations including changes in the variance risk premium, investor reactions to changes in jump risk, errors in expectations, and learning about kurtosis or other higher-order moments.
Source: SSRN Electronic Journal
Language: English
Subfield: Finance
Domain: Social Sciences
Open Access status: green
OpenAlex ID: W2195647154