Bridge over ocean
1 November 1999 Financial Analysts Journal Volume 55, Issue 6

Irrational Exuberance and Option Smiles

  1. Hersh Shefrin

Disagreement among investors is pervasive. Some investors see a trend and predict continuation; others see the same trend and predict reversal. Some investors overreact; others underreact. I explain how disagreement can and does cause markets to be inefficient. And I argue that option markets are particularly vulnerable in this respect; the “volatility smile” associated with index options is one manifestation of inefficiency stemming from heterogeneous beliefs. As part of the argument, I discuss an event study about “irrational exuberance,” the term Alan Greenspan, chair of the U.S. Federal Reserve Board, used in late 1996 to describe stock market sentiment. To study this event, I combined the information gleaned from option-pricing data with other information about market sentiment to assess the impact of heterogeneous beliefs on market efficiency.

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