Does behavioural theory explain return-implied volatility relationship? Evidence from India

Abstract

The study investigates whether behavioural theory is a superior explanation for short-term return–volatility relationship than traditional leverage and volatility feedback hypotheses. Using VAR and quantile regression frameworks, the study shows that behavioural theory explains the relationship better than the leverage and feedback hypotheses. The study supports that behavioural biases (representative, affect, extrapolation heuristics, etc.) exist among market participants, and these biases cause India Volatility Index (India VIX) to be an efficient hedge for extreme negative market movements.

Keywords

• return–volatility relation
• leverage hypothesis
• volatility feedback hypothesis
• affect heuristics
• representative bias
• extrapolation bias