SSRN Id3319502

Stock Return Extrapolation, Option Prices,
and Variance Risk Premium
Adem Atmaz∗
Krannert School of Management
Purdue University
This version: March 2021
Abstract
This paper presents a tractable dynamic equilibrium model of stock return extrapolation in the presence
of stochastic volatility. In the model, consistent with survey evidence, following positive (negative) stock
returns, investors expect future returns to be higher (lower) but also less (more) volatile. The biased volatility
expectation introduces a new channel through which past returns and investor sentiment affect derivative
prices. In particular, through this novel channel, the model reconciles the otherwise puzzling evidence of
past returns affecting option prices and the evidence of variance risk premium predicting future stock market
returns even after controlling for the realized variance.
JEL Classifications: G12, G13.

Keywords: Extrapolation, sentiment, stochastic volatility, variance bias, option prices, variance risk pre-
mium.
∗
Email address: aatmaz@purdue.edu. I thank Suleyman Basak, Andrea Buffa, Huseyin Gulen, Christian Heyerdahl-
Larsen, Fangcheng Ruan, and my discussants Mikhail Chernov, Julien Cujean, Tim Johnson, Cameron Peng, and Morad
Zekhnini, as well as the seminar participants at the 2020 Finance Down Under, 2019 CDI Conference on Derivatives,
2019 EFA meetings, 2019 NFA meetings, and 2019 Wabash River Finance Conference for helpful comments. All errors
are my responsibility.
Electronic copy available at: https://ssrn.com/abstract=3319502

1 Introduction
Growing survey evidence suggests that investors’ future stock market return expectations have ex-
trapolative biases; investors appear to expect higher future returns after good recent performance
and lower returns after bad performance, at odds with subsequent realized returns (Vissing-Jorgensen
(2003), Greenwood and Shleifer (2014), Cassella and Gulen (2018)).1 Evidence also suggests that
when investors expect higher (lower) returns after good (bad) performance, they expect lower (hig-
her) return volatility (Graham and Harvey (2001), Amromin and Sharpe (2014), Kaplanski et al.
(2016)). On the theory side, extant studies of extrapolative expectations (discussed below) primarily
focus on first-moment bias on expected returns, but do not jointly consider investors’ return volatility
expectations. This paper develops an equilibrium model of stock return extrapolation that accords
with investors’ expectations on both first- and second-moments of stock returns. The model provides
several novel implications and insights on stock prices, stock return variances, the correlation between
stock return and its variance, option prices, and variance risk premia.
In the model, a stock represents a claim to a risky payoff, determined by a fundamental process
with a constant growth rate and time-varying variance. A single investor holds correct beliefs on the
fundamental process’s growth rate, but her subjective beliefs regarding (endogenous) stock returns
include extrapolative bias. The investor’s stock return expectation bias is driven by the exponentially
weighted average of past stock returns, or sentiment. The model is highly tractable, providing analytic
option pricing formulas that nest the Heston (1993) stochastic volatility formulation and delivers
closed-form solutions for all other economic quantities.
We first determine the equilibrium stock price and show that in the presence of extrapolative
beliefs, the stock price is driven by investor sentiment in addition to the fundamental process and its
variance. Following positive stock returns, investor sentiment rises and becomes more bullish since the
investor expects future stock returns to be higher, increasing her stock demand, leading to a higher
stock price. As a new channel, we find that when the investor’s future return expectation depends
increasingly on past returns, the stock price becomes more sensitive to fundamental variance shocks.
1
Similarly, Landier, Ma, and Thesmar (2017) provide experimental evidence for extrapolative belief behavior.

We also find that stock returns become more volatile and correlate more negatively with variance
shocks due to this novel channel.
More notably, we show that extrapolating past returns while forming beliefs on future returns
generates a bias in return volatility expectations. Following positive (negative) stock returns, in
addition to expecting future stock returns to be higher (lower), the investor also expects future returns
to be less (more) volatile, consistent with survey evidence in Graham and Harvey (2001), Amromin
and Sharpe (2014), and Kaplanski et al. (2016). Such volatility bias arises in our model because the
investor reconciles her higher future return expectations when she has more bullish sentiments with
a lower expected fundamental variance, and thus less volatile stock returns. This biased variance
expectation has important implications for derivatives, such as options for which the volatility is a
key determinant of their prices, and for the risk premia investors are willing to accept for bearing the
variance risk in the stock market.
We then reconcile otherwise somewhat puzzling empirical evidence of past stock returns affecting
option prices.2 Towards that, we first obtain new analytic option pricing formulas that nest the
Heston (1993) stochastic volatility formulation. We then demonstrate that a more bearish sentiment
that follows negative stock returns leads to higher prices for both call and put options, and these
price increases are more pronounced for out-of-the-money options. In our model, these results arise
because following bad recent stock returns, in addition to expecting lower future returns, the investor
expects more volatile future returns through the volatility bias channel. Consequently, similar to the
usual vega effect, higher expected volatility leads to higher option prices, irrespective of whether the
option is a call or put. These implications of the model are consistent with empirical findings from
Bakshi and Kapadia (2003) and Amin, Coval, and Seyhun (2004) for index options. Goyal and Saretto
(2009) also provide supporting evidence in the cross-section by showing that stocks with bad recent
performance have higher option prices.
We further examine the model’s implications for variance risk premia (i.e., the difference between
the realized variance and the variance swap rate). We first obtain the variance risk premium in
2
These findings are somewhat puzzling because one of the most well-known and classic results in the option pricing
literature is that the option prices should not depend on the underlying stock’s past returns or future expected returns.

closed-form and show that more bearish sentiment leads to a more negative variance risk premium.
This result occurs because a more bearish sentiment makes the investor expect more volatile future
returns. Hence, the variance swap contract is feasible only if the variance swap rate is higher, leading
to a more negative variance risk premium. Extant theoretical research attributes fluctuations in the
variance risk premium to various shocks, such as time-variation in risk aversion (Bekaert and Engstrom
(2010)), time-variation in aggregate consumption variance (Bollerslev, Tauchen, and Zhou (2009)),
Poisson shocks to expected aggregate consumption mean and variance (Drechsler and Yaron (2011)),
Knightian uncertainty shocks (Drechsler (2013), Miao, Wei, and Zhou (2019)), and time-variation
in volatility under cumulative prospect theory (Baele et al. (2019)). Therefore, one contribution of
the current study is complementing this literature by identifying a new economic determinant of the
variance risk premium—past-returns-driven investor sentiment.
The variance risk premium has recently attracted much attention in the literature because of
growing evidence that suggests it predicts future stock market returns. By examining its predictive
power in a univariate regression in our model, we show that a more negative variance risk premium
leads to higher future stock returns, consistent with vast empirical evidence (Bollerslev, Tauchen, and
Zhou (2009), Drechsler and Yaron (2011), Bollerslev, Todorov, and Xu (2015), Kilic and Shaliastovich
(2019), Pyun (2019)). Such predictability arises in the model because a more negative variance
risk premium largely indicates more bearish investor sentiment. Since bearish sentiment coincides
with a stock price lower than that justified by its fundamentals, subsequent observed stock returns
become higher, on average. Using joint regressions, we further show that the variance risk premium
predicts future stock returns negatively even after controlling for realized (or conditional) variance,
also consistent with Bollerslev, Tauchen, and Zhou (2009).
Finally, we assess the model’s quantitative performance, demonstrating that the effects of extra-
polative expectations on stock market quantities, option prices, and the variance risk premium are
economically significant. In our quantitative analysis, we also examine the relationship between the
predictive power of the variance risk premium and the tendency of stock returns and their volatility
to move in opposite directions, often called the leverage effect, finding a positive relationship that
accords with recent evidence from Pyun (2019).

This paper contributes to growing theoretical literature on how investors’ extrapolative beliefs
affect asset prices. In this literature, investors’ extrapolative beliefs are based on either endogenous
stock returns, as in the current paper (De Long et al. (1990), Hong and Stein (1999), Barberis et al.
(2015, 2018), Adam, Marcet, and Beutel (2017), Jin and Sui (2018), Li and Liu (2018)), or exogenous
fundamentals (Barberis, Shleifer, and Vishny (1998), Choi and Mertens (2013), Alti and Tetlock
(2014), Hirshleifer, Li, and Yu (2015), Lochstoer and Muir (2019)).3 The former models, in which
investors extrapolate endogenous stock returns, are typically much more difficult to solve and more
directly supported by survey evidence than the latter models.
Among above works, papers that most closely relate to ours are Adam, Marcet, and Beutel
(2017), Jin and Sui (2018), Li and Liu (2018). Adam, Marcet, and Beutel (2017) develop a model
in which investors with power preferences hold rational expectations about the fundamentals but
do not know the equilibrium pricing function. In their model, investors perceive that stock returns
have an unobservable, persistent component that must be filtered from past returns. They show that
optimal filtering leads to investors’ capital gain expectations to co-move positively with the price-
dividend ratio, consistent with survey evidence. Jin and Sui (2018) study the quantitative effects of
extrapolative beliefs in an economy in which the representative agent has Epstein-Zin preferences.
Li and Liu (2018) study an economy in which the representative agent has power preferences and
find that extrapolative beliefs have significant effects on the interest rate. Our paper differs from
these studies regarding various aspects related to methodology, mechanisms, and predictions. For
example, in all these models, consistent with the long-standing view, the fundamentals have i.i.d.
growth rates, and thus extrapolating past stock returns does not generate variance bias. In contrast,
in our model, consistent with recent evidence in Schorfheide, Song, and Yaron (2018) and Pettenuzzo,
Sabbatucci, and Timmermann (2020), the fundamental has heteroskedastic growth rates, resulting in
extrapolating past stock returns that generate variance bias, which is the essential mechanism behind
our main results regarding option prices and the variance risk premium.
The remainder of the paper is organized as follows. Section 2 presents a summary of survey
evidence and our extrapolative beliefs model. Section 3 discusses results regarding the equilibrium
3
A similar belief structure also arises in models in which investors base their beliefs on their past experiences (Ehling,
Graniero, and Heyerdahl-Larsen (2017), Malmendier, Pouzo, and Vanasco (2017), Nagel and Xu (2018)).

stock price and stock return variance, and Section 4 regarding option prices and variance risk premium.
Section 5 assess the model’s quantitative performance, and Section 6 concludes. Appendix contains
all proofs.
2 Economy with Extrapolative Beliefs
In this section, we first summarize survey evidence regarding how future stock returns and volatility
expectations relate to past returns. We then introduce our model in which a representative investor’s
future stock return expectations have an extrapolative belief component that is driven by past stock
returns.
2.1 Survey Expectations and Past Returns
Table 1 presents a summary of survey evidence on how stock returns and volatility expectations relate
to past stock returns. Using the Gallup survey question for sample period 1998–2002 “Thinking
about the stock market more generally, what overall rate of return do you think the stock market
will provide investors during the coming twelve months?” Vissing-Jorgensen (2003) finds a positive
relationship between average expectations and stock market levels, indicating extrapolative belief
formation regarding future returns. In the survey, the average expected one-year stock-market return
was 15.8% during January 2000, when the market was at its highest in the sample, but 6% at the end
of 2002, when the market was nearly at its lowest. In terms of expected excess returns, expectations
correspond to 10.3% and 4.8%, respectively. In more recent research that uses various surveys,
including the Gallup survey for the sample period 1996–2011, Greenwood and Shleifer (2014) find the
average expectation to be around 10.5%. They also find that a 20% increase in the stock price during
the previous year (an increase of nearly one standard deviation of returns) increases the stock return
expectation by 1.8%, again indicating extrapolative belief formation regarding future returns.
Some studies additionally look at survey expectations on return volatility and its relationship
with past returns. During 2000 and 2001, Graham and Harvey (2001) asked chief financial officers

Table 1: Summary on survey expectations and past returns. This table summarizes the empirical
works studying the survey expectations on stock returns and return volatility and how they are related to
past stock returns. The quantities in parentheses refer to expectations of excess returns, stock market return
expectation minus the corresponding riskless rate.
Stock return Stock volatility

expectation expectation
At market peak 15.8% (10.3%) −−
Vissing-Jorgensen (2003) At normal times 11.8% (6.9%) −−
At market trough 6.0% (4.8%) −−
High past returns 12.3% (9.31%) −−
Greenwood and Shleifer (2014) Mean 10.5% (7.51%) −−
Low past returns 8.7% (5.71%) −−
High past returns 7.44% (2.49%) 6.72%
Graham and Harvey (2001) Mean 6.55% (1.60%) 7.01%
Low past returns 5.66% (0.71%) 7.30%
High past returns 10.7% (8.35%) lower
Amromin and Sharpe (2014) Mean 9.1% (6.75%) 9.4% − 13.2%
Low past returns 7.5% (5.15%) higher
High past returns higher lower
Kaplanski et al. (2016) Mean average average
Low past returns lower higher
(CFOs) in U.S. corporations about next year’s expected returns on the S&P 500 and their expectations
regarding a 1-in-10 chance that returns would be higher/lower than that value. They find that average
expectations on the risk premium and volatility (after converting the 1-in-10 chance into a standard
deviation) to be 1.60% and 7.01%, respectively, which are significantly lower than their historical
realized averages. They also find that recent performance of the S&P 500 has a significant effect on
short-term (i.e., 1-year) expectations on the risk premium and volatility. Regression results suggest
that a 10% increase in the stock price during the previous quarter increases risk premium expectations
by 0.89%, while lowering volatility expectations by 0.29%. Using Michigan survey data for the sample
period 2000 to 2005 and a question that asked about the likelihood of the average return over the
next 10 to 20 years being within ±2% of their expected average return, Amromin and Sharpe (2014)
estimate median annual stock return volatility to be between 9.4% and 13.2%, after conversion under

certain assumptions. They further find evidence of countercyclical perceived equity risk; respondents
expect lower volatility when they also expect future economic conditions to be good. Using the LISS
panel of CentERdata in the Netherlands for the November 2010 to July 2011 period and the perceived
risk question “How do you consider the U.S. stock market risk (volatility) for the coming month/year
relative to an average year?,” with one being “much less risky” to five being “much riskier”, Kaplanski
et al. (2016) find that expectations regarding future and past returns move together, whereas perceived
risk (volatility) decreases with past realized returns.
As the discussion above illustrates, the availability of direct quantitative questions on stock market
return expectations in surveys allows researchers to quantify average expectations and its relationship
to past returns straightforwardly and precisely. In contrast, absent direct quantitative questions
regarding stock volatility expectations, the literature commonly relies on qualitative findings, or uses
imperfect conversion methods to quantify volatility estimates, which lead to much lower volatility
expectations than historical realized averages.
2.2 Model
We introduce a stock return extrapolation model that accords with the investor expectations discussed
in Section 2.1. We consider a continuous-time economy that is populated by a single investor with
horizon T . Two securities are available for trading—a risky stock that represents the stock market
and a zero-coupon bond. The stock is in fixed supply of one unit and is a claim to the single risky
payoff DT , which is the time T realization of the fundamental (e.g., cash-flow news) D with dynamics:
p
dDt = Dt [µdt + Vt dω1t ], (1)
p q p
dVt = (ζ − κVt )dt + ρσ Vt dω1t + 1 − ρ2 σ Vt dω2t , (2)
where µ is the constant mean growth rate, V is the stochastic variance of the fundamental process,
and ω1 , ω2 are independent Brownian motions under the objective measure P. Positive constants
κ, σ, ζ/κ represent the mean reversion speed, volatility, and long-term mean of the fundamental
variance V , respectively, and ρ is the correlation coefficient between the fundamental process and

its variance.4 The growth rate of the fundamental having a time-varying variance is consistent with
empirical findings in Schorfheide, Song, and Yaron (2018) and Pettenuzzo, Sabbatucci, and Timmer-
mann (2020), who find evidence of heteroskedasticity in cash-flow growth rates.5 Stock price S is
determined endogenously in equilibrium, and is posited to follow:
dSt = St [µSt dt + σS1t dω1t + σS2t dω2t ] , (3)
where µS is the true stock mean return and σS1 , σS2 are diffusion terms that determine return
volatility. The zero-coupon bond is in zero-net supply, paying constant interest rate r.6
As discussed in Section 2.1, survey evidence suggests that many investors extrapolate past stock
market returns while forming future return expectations. Such expectations have been shown to
contradict subsequent realized returns, indicating (extrapolative) biases in investors’ expectations.
Consistent with this evidence, we model the investor’s subjective beliefs—the consensus belief—on
expected stock returns as having an extrapolative bias component. At all times t, the investor observes
stock price St and its diffusion terms σS1t and σS2t , but misperceives its mean return as µSt + θXt
instead of the true one, µSt . Process X in the subjective mean return is the (exponentially decaying)
4
In our analysis, we impose the restriction −1 < ρ ≤ 0, which is the simplest sufficient (but not necessary) condition
to restrict our attention to the empirically relevant case of negative correlation between the stock returns and the changes
in its variance, as observed in data (French, Schwert, and Stambaugh (1987), Glosten, Jagannathan, and Runkle (1993)).
That being said, in our baseline quantitative analysis, we simply set ρ = 0 to highlight that our main results are not
due to the negativity of ρ. Moreover, since the fundamental variance V is a square-root process, it can be guaranteed
to have positive values in finite samples by imposing 2ζ > σ 2 . Without loss of generality, we also set the initial value of
the fundamental variance to its long-run mean, V0 = ζ/κ, for convenience.
5
In particular, Schorfheide, Song, and Yaron (2018) use Bayesian state-space models and provide evidence for he-
teroskedasticity in the growth rates of cash-flow (consumption, output, dividends). Pettenuzzo, Sabbatucci, and Tim-
mermann (2020) employ high frequency (daily) firm-level dividend announcements to construct a “bottom-up” measure
of aggregate cash-flow news and attribute the source of the stochastic variance to firms in similar industries clustering
their dividend announcements. They also detect a predictable mean and a jump component for the cash-flow news
process. However, for simplicity, we shut down these components in our specification in (1), since they are not essential
for our main mechanisms. We also highlight that the fundamental process having a stochastic variance is also commonly
employed in asset pricing models, particularly in the long-run risk models (e.g., Bansal and Yaron (2004)), and is also
present in Eraker and Wu (2017) with a securities market setting similar to ours.
6
In our setting, the stock is a claim to a single payoff. Therefore, the interest rate can be taken as given. In our
quantitative analysis, we set the interest rate to its historical average in the U.S. This setting is suitable for our purposes
since it provides the well-understood Heston (1993) stochastic volatility model as a benchmark model. Other dynamic
asset pricing models in which the stock is a claim to a single payoff like us include Kogan et al. (2006), Cvitanić and
Malamud (2011), Pástor and Veronesi (2012), Basak and Pavlova (2013), and Eraker and Wu (2017).

Rt −α(t−u) d ln S ,
weighted average of past stock returns, Xt ≡ −∞ αe u with implied dynamics:
dXt = −αXt dt + αd ln St , (4)
where positive constant α (henceforth, the relative weight) controls the weights on the most recent
returns in the construction of X, with a higher value assigning more weights to the most recent
returns. Following common convention in extrapolative expectations literature (e.g., Barberis et al.
(2015)), we refer to the weighted past returns process X as the sentiment, since it drives the future
stock return expectation bias (i.e., the difference between subjective and objective expected returns).7
Therefore, following positive (negative) stock returns, sentiment rises (falls) and becomes more bullish
(bearish) as the investor expects future returns to be higher (lower). Positive constant θ (henceforth,
the extrapolation degree) controls the extent to which past returns are reflected in future stock return
expectation, with the rational benchmark economy, in which the investor has no bias, obtained by
setting θ = 0.
Since two sources of uncertainty are present in the economy, to characterize the investor’s sub-
jective probability measure fully, we specify her beliefs regarding one more process.8 We assume that
the investor holds correct beliefs concerning the growth rate of the fundamental process (1). That
is, the investor observes the fundamental Dt , its mean growth rate µ, its variance Vt , and hence the
Brownian motion ω1 at all times t. Therefore, the investor perceives the stock price dynamics as:
s
dSt = St [(µSt + θXt ) dt + σS1t dω1t + σS2t dω2t ], (5)
where ω2s is the Brownian motion under the investor’s subjective measure Ps , given by dω2t
s = dω −
2t
7
Referring to the process X as the sentiment is also consistent with Baker and Wurgler (2007) definition. They define
the sentiment broadly as the belief about future cash flows and investment risks that are not justified by the facts at
hand. Moreover, referring the process X as the sentiment is also consistent with the widespread usage of the term in
empirical studies. This is because the process X is driven by past stock market returns in our model, and as Brown and
Cliff (2004) show, the past stock market returns are important determinants of commonly employed sentiment measures
in empirical studies.
8
In contrast, extrapolating the endogenous stock returns alone is sufficient to fully characterize the investors’ sub-
jective measure in the models with one source of uncertainty (e.g., Barberis et al. (2015)). This case can also arise in
our setting with ρ = −1, in which all quantities are driven by the single Brownian motion ω1 . Even though we omit the
analysis for brevity, one can show that our main economic mechanisms and results also obtain in this polar case.

(θXt /σS2t )dt, which follows from equating (3) and (5). The investor holding correct beliefs about
the fundamental growth rate accords with evidence in Greenwood and Shleifer (2014), who find that
average investor expectations of stock market returns are a positive function of past returns, but do
not depend significantly on past fundamental growth rates. That being said, as we also discuss in
Remark 2 of Section 3, this assumption is neither necessary nor crucial for our main results.9 Our
main mechanisms and results also obtain when the investor also has biased expectations regarding the
fundamental growth rate (1). Therefore, our framework is not necessarily at odds with, and can also
support the recent findings in De La O and Myers (2019) and Bordalo et al. (2020), who find evidence
of extrapolative expectations on fundamentals. We leave the study of incorporating this additional
channel into our framework for future research.
The investor’s optimization problem is such that she chooses an admissible dynamic portfolio
strategy ψ, the number of shares of the stock, to maximize her logarithmic preferences over WT , the
value of her portfolio at time T :
max Es [ln WT ] , (6)
ψ
subject to her dynamic budget constraint:
dWt = (Wt − ψt St ) rdt + ψt dSt , (7)
where Es denotes the expectation under the investor’s subjective measure Ps .10
Remark 1 (Further discussion on extrapolative beliefs). In a single agent economy like ours,
the investor’s belief is “the consensus belief” that matters in determining asset prices. Our consensus
9
For our main results, the crucial feature of our model is the presence of stochastic volatility in stock returns, which
is one of the most well-established stylized facts of stock market returns.
10
Dependence of the subjective Brownian motion ω2s on two endogenous quantities X and σS2 complicates our analysis
since solving for the equilibrium now necessarily involves conjecturing and later verifying a stock price form. For this
reason, we consider simple logarithmic preferences with no intertemporal consumption, which significantly simplifies
the verification step while also being sufficient to demonstrate our main mechanism and generate rich equilibrium
implications as our subsequent sections demonstrate. Moreover, as we show in Section 3, the stock price behavior with
respect to sentiment in our model is similar to that of Barberis et al. (2015), which employs intertemporal consumption.
This observation suggests that the presence or lack of intertemporal consumption is not crucial to capture the essential
effects of extrapolative expectations on asset prices. These issues do not arise in models in which investors’ subjective
Brownian motions depend on exogenous processes, which typically can be studied rather tractably under more general
isoelastic preferences with or without intertemporal consumption, and even with investor heterogeneity (e.g., Dumas,
Kurshev, and Uppal (2009)).
10

belief specification is motivated by the fact that a similar form arises in heterogeneous agent economies
in which the consensus belief is the weighted average beliefs of investors (e.g., Jouini and Napp (2007),
Atmaz and Basak (2018)). For example, in Barberis et al. (2015), there are two types of investors—
rational investors and extrapolators—with respective expectations corresponding to µSt and Xt in our
model. Although Barberis et al. do not construct it, the representative agent’s consensus expectation
can be obtained as the weighted average of µSt and Xt . Our consensus belief specification, µSt + θXt ,
captures the essentials of the consensus belief in a simply way. Thus, one could also think the
extrapolation degree θ in our model as a parameter that controls the population size of extrapolative
investors in reality.11
For equilibrium to exist in a representative agent economy, the investor’s expectations cannot be
purely the extrapolative term Xt , but must include the true expected return, µSt , to some degree.
Otherwise, following a positive fundamental shock, the investor would keep pushing up the stock
price, which would lead to an explosive stock price behavior and a nonexistent equilibrium. Again,
this accords with Barberis et al., who show that equilibrium would not exist if all investors are
extrapolators in their model.
To maintain an asset pricing focus, we do not model the underlying economic source of extrapo-
lative belief formation, but the literature suggests the heuristic of representativeness, or the related
law of small numbers, for its source (Rabin (2002), Rabin and Vayanos (2010)). Under the law of
small numbers, when investors do not know the true data-generating process, they expect outcomes
in random sequences to be excessively persistent by inferring too quickly based on a small sample.
Following high stock returns, investors thus deduce that future returns will also be higher.
3 Extrapolative Beliefs Equilibrium
In this section, we investigate how extrapolating past stock returns affects the equilibrium stock price
and the stock return variance in our economy. We find that the magnitude of the fundamental variance
elasticity of the stock price and the negative correlation between the stock return and its variance
11
Alternatively, we could model the investor’s perceived mean return as a convex combination of µSt and Xt , that is,
(1 − θ) µSt + θXt , for θ ∈ (0, 1). This specification also leads to similar results.
11

are increasing in the extrapolation degree. More notably, we show that extrapolating past returns
while forming beliefs about future returns generates a bias in return variance expectations. Following
positive (negative) stock returns, in addition to expecting future stock returns to be higher (lower),
the investor expects future returns to be less (more) volatile, consistent with survey evidence.
Equilibrium in our economy is defined in a standard way. The economy is in equilibrium if stock
price S and the investor’s portfolio strategy ψ are such that the investor chooses her optimal portfolio
strategy given the stock price, goods market clear at horizon T (DT = WT ), and stock and bond
markets clear at all times t ≤ T (ψt = 1 and Wt − ψt St = 0). We denote corresponding quantities
in the rational benchmark economy with an upper bar (¯). To avoid time-to-maturity effects, we also
consider an infinite-horizon (stationary) economy by letting T → ∞.12 Proposition 1 presents the
equilibrium stock price St and summarizes its properties in our economy (henceforth, the economy
with extrapolative beliefs).
Proposition 1 (Equilibrium stock price). In the economy with extrapolative beliefs, the equili-
brium stock price is:
St = Dt ea+bVt +cXt , (8)
where the sentiment elasticity of the stock price, c = ∂ ln St /∂Xt , and the fundamental variance
elasticity of the stock price, b = ∂ ln St /∂Vt , that represent the percentage change in the stock price in
response to a unit change in the sentiment and the fundamental variance, respectively, are:
θ
c = , (9)
α (1 + θ)
2+θ
b = − q , (10)
κ + ρσ (1 + θ) + (κ + ρσ (1 + θ))2 − σ 2 (1 + θ) (2 + θ)
12
We note that the finite-horizon version of our model, T < ∞, also generates our main results and insights, albeit
in a non-stationary equilibrium and much less tractable way. In contrast, by removing the time-to-maturity effects,
an infinite-horizon economy leads to a tractable stationary equilibrium, which can also be calibrated straightforwardly.
Moreover, the stationary economy allows us to obtain the stock price in closed-form and carry out a simple comparative
statics analysis, and therefore helps us understand the effects of the extrapolative beliefs on asset prices better. The
stationary equilibrium also leads to a simple stock price expression and derivative prices in equilibrium. For instance, the
well-known stochastic volatility option pricing model of Heston (1993) arises as a special case of our stationary equilibria
(Section 4). One recent example in the literature that also considers the infinite-horizon limit to avoid time-to-maturity
effects is Eraker and Wu (2017).
12

and a is some constant, with the parameter restriction of r − µ − ζb − rαc = 0. The fundamental D,
the fundamental variance V , and the sentiment X follow (1), (2), and (4), respectively.
In the rational benchmark economy, the equilibrium stock price is S̄t = Dt eā+b̄Vt , where its fundamental
q
variance elasticity, b̄ = ∂ ln S̄t /∂Vt , is b̄ = −2/(κ + ρσ + (κ + ρσ)2 − 2σ 2 ), and ā is some constant,
with parameter restriction r̄ − µ − ζ b̄ = 0.
Consequently, in the economy with extrapolative beliefs,
i) the stock price is increasing in sentiment Xt , but is decreasing in fundamental variance Vt ,
ii) the sentiment elasticity is increasing in the extrapolation degree θ, but is decreasing in the relative
weight α,
iii) the fundamental variance elasticity is decreasing in the extrapolation degree θ.
In the rational benchmark economy, the stock price is driven by the fundamental D and its variance
V in the usual way. A higher current fundamental indicates a higher future stock payoff, leading to a
higher stock price, whereas a higher current fundamental variance indicates a more uncertain future
stock payoff, leading to a lower stock price, since the investor is risk-averse. These mechanisms are
also present in our economy because having extrapolative beliefs does not alter the investor’s risk
attitude and preferences for higher stock payoff. However, the stock price is now additionally driven
by and positively associated with sentiment X (Property (i)). Following positive stock returns (either
due to a higher fundamental D or a lower fundamental variance V , or both to some degree), the
investor’s sentiment rises and becomes more bullish, increasing the investor’s stock demand. Since
the stock is in fixed supply, increased demand leads to a higher stock price. Conversely, following
negative stock returns, the investor’s sentiment falls and becomes more bearish, leading to a lower
stock price.
Under equilibrium, the sentiment elasticity c > 0 and fundamental variance elasticity b < 0 are
simple constants, given by (9)–(10) in closed-form.13 A higher extrapolation degree θ leads to a
13
We also note that for the stock price in our infinite-horizon economy to be well-defined and finite-valued, we need
to impose the parameter restriction of r − µ − ζb − rαc = 0 as stated in Proposition 1. As our discussion in the
determination of model parameter values in Section 5 illustrates, for economically plausible parameter values of our
model, this restriction is easily satisfied. Moreover, as the denominator of (10) illustrates, to ensure that the equilibrium
stock price admits a real solution we need to impose the parameter restriction (κ + ρσ (1 + θ))2 > σ 2 (1 + θ) (2 + θ).
13

higher sentiment elasticity because it increases the investor’s future stock return expectation directly.
However, a higher relative weight α makes the sentiment process driven primarily by the most recent
returns, making it less persistent and revert to its mean more rapidly, which in turn, makes the
stock price less sensitive to changes to sentiment (Property (ii)). As a novel result, we find that
a higher extrapolation degree θ leads to a more negative fundamental variance elasticity b, thereby
making the stock price more sensitive to fundamental variance shocks (Property (iii)). As (3) shows,
fundamental variance shocks, ω2 , are also part of the equilibrium stock returns. When the investor’s
future stock return expectation becomes more sensitive to past returns (i.e., a higher θ), it also becomes
more sensitive to fundamental variance shocks. Therefore, following positive (negative) fundamental
variance shocks, the investor expects future returns to be lower (higher) and hence pushes the stock
price down (up) more when her expectation is more sensitive to past returns.
We present the equilibrium stock return variance ϑt = Vart [dSt /St ] /dt, and the correlation bet-
p
ween the stock return and its variance (changes) ρSϑ = Covt [dSt /St , dϑt ] / Vart [dSt /St ] Vart [dϑt ],
in closed-form, and summarize their properties in our stationary economy in Proposition 2.
Proposition 2 (Equilibrium stock return variance and correlation). In the economy with
extrapolative beliefs, the equilibrium stock return variance is:
1 + 2ρσb + σ 2 b2
ϑt = Vt , (11)
(1 − αc)2
and the equilibrium correlation between the stock return and its variance is:
ρ + σb
ρSϑ = p , (12)
1 + 2ρσb + σ 2 b2
where sentiment elasticity c and fundamental variance elasticity b are as in Proposition 1.

In the rational benchmark economy, the equilibrium stock return variance is ϑ̄t = 1 + 2ρσ b̄ + σ 2 b̄2 Vt ,
q
and the equilibrium correlation between the stock return and its variance is ρ̄Sϑ = (ρ+σ b̄)/ 1+2ρσ b̄+σ 2 b̄2 ,
where fundamental variance elasticity b̄ is as in Proposition 1.
Consequently, in the economy with extrapolative beliefs,
i) the stock return variance is increasing in the extrapolation degree θ,
14

ii) the correlation between the stock return and its variance is decreasing in the extrapolation degree
θ.
The equilibrium stock return variance (11) has a simple form proportional to the fundamental
variance, and thus also follows a stationary square-root process. We find that a higher extrapolation
degree θ leads to a higher stock return variance (Property (i)). In our model, this occurs due to two
channels. The first has already been identified in extant research on extrapolative expectations with
constant volatility (e.g., Barberis et al. (2015)), and is due to the amplification term 1/(1−αc) = 1+θ
that arises from extrapolating endogenous stock returns. Following positive (negative) stock returns,
the investor expects future returns to be higher (lower) and thus pushes the stock price further up
(down), and this additional fluctuation in the stock price leads to higher return variance. However,
the second channel is novel to our model with stochastic volatility, and it arises because a higher
extrapolation degree also increases the magnitude of the fundamental variance elasticity b (Proposition
1). Therefore, the stock price becomes more sensitive to the fundamental variance shocks, leading to
more volatile stock returns.
Our framework with two sources of uncertainty allows us to investigate the effects of extrapolative
beliefs on the correlation between the stock return and return variance. As a novel result, we find that
a higher extrapolation degree θ leads to a more negative correlation by increasing its magnitude, thus
leading to more negatively skewed stock market returns (Property (ii)). This result arises because
a higher extrapolation degree leads to greater negative fundamental variance elasticity by increasing
its magnitude (Proposition 1). Therefore, the stock price becomes more sensitive and moves in the
opposite direction more following fundamental variance, or equivalently, the stock return variance,
shocks.
Having determined the equilibrium stock return variance, we examine the investor’s expectation
of it. Proposition 3 presents the investor’s subjective expectation of the equilibrium stock return
variance (changes), Est [dϑt ], along with its key property in our stationary economy.
15

Proposition 3 (Equilibrium stock return variance expectation). In the economy with extra-
polative beliefs, the subjective expectation of the equilibrium stock return variance is:
Est [dϑt ] /dt = Et [dϑt ] /dt + ηϑ Xt , (13)
where:
θ 1 + 2ρσb + σ 2 b2
ηϑ = , (14)
b 1 − αc
and Et [dϑt ] /dt = ζϑ − κϑt , with ζϑ = ζ(1 + 2ρσb + σ 2 b2 )/ (1 − αc)2 , and sentiment elasticity c and
fundamental variance elasticity b are as in Proposition 1.
In the rational benchmark economy, the subjective expectation of the equilibrium stock return variance
h i h i h i
is Est dϑ̄t /dt = Et dϑ̄t /dt, where Et dϑ̄t /dt = ζ̄ϑ − κϑ̄t , with ζ̄ϑ = ζ(1 + 2ρσ b̄ + σ 2 b̄2 ), and
fundamental variance elasticity b̄ is as in Proposition 1.
Consequently, in the economy with extrapolative beliefs, the subjective expectation of the future stock
return variance is decreasing in sentiment Xt .
Proposition 3 shows that in the presence of stochastic stock return volatility, extrapolating past
returns while forming beliefs about future returns generates a bias in return variance expectations,
with sentiment Xt driving the variance bias. The key implication is that when the investor has a
more bullish sentiment and expects higher future returns, she also expects less volatile future returns,
consistent with evidence in Graham and Harvey (2001), Amromin and Sharpe (2014), and Kaplanski
et al. (2016).14 As (3) shows, equilibrium stock returns are driven by fundamental growth rate shocks
ω1 and variance shocks ω2 . Since the investor holds correct beliefs regarding the fundamental growth
rate (1) and its shocks ω1 , any bias in her subjective stock return expectation alters her beliefs
concerning the fundamental variance shock ω2 , as (5) also illustrates. When the investor has a more
bullish sentiment, she pushes the stock price up more and reconciles the additional price increase by
expecting less volatile future fundamental growth rates, and thus less volatile stock returns. As we
show in Section 4, this novel volatility bias channel helps us reconcile otherwise somewhat puzzling
evidence concerning option prices being affected by past returns.
14
Adelino, Schoar, and Severino (2018) find a similar volatility bias in the housing market by showing that households
extrapolate past house price changes when they form their expectations of future house price risk (variance) such that
large recent price drops lead to more perceived risk.
16

Remark 2 (Further discussion of variance bias). We find it helpful to elaborate on the volatility
bias mechanism, given its novelty and importance. Our message is that when stock returns exhibit
stochastic volatility, extrapolating past stock returns while forming expectations on future returns
can lead to biased return volatility expectations. To illustrate this mechanism clearly, we assume that
the investor holds correct beliefs on the mean growth rate of fundamental µ, discussed in Section
2. However, this assumption is neither necessary nor crucial for return variance bias to arise in
equilibrium in our framework. A similar return variance bias also arises when the investor holds
biased expectations on both the fundamental growth rate (1) and fundamental variance (2).
The simplest method of obtaining the variance bias and a biased fundamental expected growth
rate is to take the correlation coefficient ρ = −1, which implies that the fundamental, fundamental
variance, and stock price all correlate perfectly. In this case, extrapolating high past stock returns
leads to both a higher expected fundamental growth rate and a lower expected fundamental variance,
thereby yielding a similar variance bias channel and the results as in our main model. An alternative
method is to consider an imperfect correlation structure, −1 < ρ < 0, along with the assumption that
the investor does not observe the fundamental mean growth rate µ and hence its shock ω1 . In this case,
extrapolating past stock returns alters beliefs about the shock ω1 . Through the correlation channel,
extrapolating past stock returns leads to a bullish sentiment along with both a higher expected
fundamental growth rate and a lower expected fundamental variance, and consequently biased return
variance expectations in equilibrium. Our model captures the variance bias mechanism observed in
the data without unnecessarily confounding analyses with more complex fundamental growth rate
expectations, which do not play a role in our main results for derivative prices in Section 4.
We also highlight that the variance bias channel is distinct from the correlation channel; stock re-
turn volatility tends to be lower when stock returns are positive, due to a negative correlation between
the stock return and its variance, ρSϑ < 0. Findings for Proposition 3 show that were this correla-
tion zero, the investor would still expect future returns to be less volatile following positive returns.
Finally, we note that although volatility can be estimated accurately using historical and intra-day
data, estimating the conditional expectation of volatility changes in practice remains challenging for
many investors, which might explain observed biases in volatility expectations in surveys.
17

4 Option Prices and Variance Risk Premium
In this section, we study the option prices and variance risk premium in our economy with extra-
polative beliefs. We first obtain new analytic option pricing formulas that are affected by investor
sentiment, finding that a more bearish sentiment following negative stock returns leads to higher call
and put option prices, and price increases are more pronounced for out-of-the-money options, consis-
tent with empirical evidence. We then obtain a closed-form solution for the variance risk premium,
showing that a more bearish sentiment leads to a more negative variance risk premium. More notably,
we find that the variance risk premium predicts future stock returns negatively, even after controlling
for the realized (or conditional) variance, also consistent with empirical evidence.
4.1 Option Prices
Several empirical studies show that past stock returns affect option prices (e.g., Bakshi and Kapadia
(2003), Amin, Coval, and Seyhun (2004), Goyal and Saretto (2009)). These findings are somewhat
puzzling because a classic result in the literature is that option prices do not depend on an underlying
stock’s past or future expected returns.15 We offer an explanation for this somewhat puzzling evidence
by demonstrating that past stock returns and investor sentiment can affect option prices through a
biased volatility expectation channel. We consider standard European-style call and put options
with strike prices K and maturity dates To , and present their equilibrium prices in our economy in
Proposition 4.
Proposition 4 (Equilibrium option prices). In the economy with extrapolative beliefs, the equili-
brium call and put option prices are:
Ct = St Ψ1 (ln St , ϑt , Xt , t) − Ke−r(To −t) Ψ2 (ln St , ϑt , Xt, t) , (15)
Pt = −St (1 − Ψ1 (ln St , ϑt , Xt , t)) + Ke−r(To −t) (1 − Ψ2 (ln St , ϑt , Xt, t)) , (16)
where conditional probability function Ψj (s, v, x, t), for j = 1, 2, appears in the Appendix.
15
See, for example, the classic option pricing theories of Black and Scholes (1973) and Merton (1973), or the theories
with richer stock return dynamics of Heston (1993) and Duffie, Pan, and Singleton (2000).
18

In the rational benchmark economy, the equilibrium call and put option prices are as in Heston (1993)
and given by C̄t = S̄t Ψ̄1 (ln S̄t , ϑ̄t , t) − Ke−r̄(To −t) Ψ̄2 (ln S̄t , ϑ̄t , t), and
P̄t = −S̄t (1 − Ψ̄1 (ln S̄t , ϑ̄t , t)) + Ke−r̄(To −t) (1 − Ψ̄2 (ln S̄t , ϑ̄t , t)), where conditional probability function
Ψ̄j (s, v, t), for j = 1, 2, appears in the Appendix.
In the rational benchmark economy, option prices are as in the stochastic volatility model of
Heston (1993), driven by stock price and its conditional return variance. However, in the presence of
extrapolative beliefs, option prices are additionally driven by investor sentiment X, as (15)–(16) show.
Investor sentiment affects option prices because while adjusting for risks, investors’ biases should be
considered. Since investor sentiment drives variance bias (Proposition 3), it also manifests in the
expected stock return variance under the risk-neutral measure (see Lemma A1 in the Appendix), and
consequently in option prices. To assess how investor sentiment affects option prices in the model, we
use numerical analysis and report quantitative effects in Table 2.16
Table 2 reports that in the rational benchmark economy (θ = 0), option prices are as in Heston
(1993) and do not vary across degrees of sentiment. However, in the presence of extrapolative beliefs
(θ > 0), both put and call option prices are higher under a bearish sentiment, as the uniform positivity
of the terms in the % Diff. columns indicate. This result arises in our model because a more bearish
sentiment due to bad recent stock returns also makes the investor expect future returns to be more
volatile. Consequently, higher expected stock return volatility, similar to the usual vega effect, leads to
higher option prices, irrespective of whether the option is a put or call. Table 2 also reveals that price
increases under a bearish sentiment are more pronounced for out-of-the-money options (K/St = 0.9
for the put, K/St = 1.1 for the call). These implications are consistent with empirical evidence
from Bakshi and Kapadia (2003), who find that index options become more expensive (cheaper)
after extreme negative (positive) past returns, holding everything else constant (see their Table 6).
16
√ month maturity options when the stock price is St = 100 and the stock return volatility
In Table 2, we consider three
is at its steady-state value of ϑt = 16.36%. We report three different option moneyness K/St levels and four different
extrapolation degrees, in which θ = 0 corresponds to the rational benchmark economy yielding standard Heston prices,
and θ = 0.25 our baseline extrapolation degree. We also consider three different sentiment levels, no sentiment (Xt = 0),
the bearish sentiment that is one standard deviation lower than zero (Xt = −0.07), and the bullish sentiment that is
one standard deviation higher than zero (Xt = 0.07). We report the percentage difference of option prices at the bearish
sentiment from those at bullish sentiment in the last columns (% Diff.).
19

Table 2: Option prices. This table reports the put and call option prices for varying levels of option
moneyness K/St , extrapolation degree θ, and sentiment Xt . The last columns report the percentage difference
of option prices at the bearish sentiment that is one standard deviation lower than zero (Xt = −0.07) from
the bullish sentiment that is one standard deviation higher than zero (Xt = 0.07). The option maturity is 3
months, the current stock price is St = 100, the current stock return volatility is 16.36% (steady-state value),
and all the other parameter values are as in Table 4.
Put option Call option

Xt Xt
K/St θ -0.07 0 0.07 % Diff. -0.07 0 0.07 % Diff.
0 0.45 0.45 0.45 0% 10.57 10.57 10.57 0%
0.25 0.54 0.52 0.49 9.21% 10.66 10.64 10.62 0.43%
0.9
0.50 0.66 0.61 0.55 19.11% 10.79 10.73 10.68 0.99%
0.75 0.91 0.81 0.69 32.25% 11.04 10.94 10.82 2.06%
0 3.14 3.14 3.14 0% 3.28 3.28 3.28 0%

0.25 3.20 3.15 3.09 3.69% 3.34 3.29 3.23 3.53%
1
0.50 3.30 3.17 3.04 8.31% 3.44 3.31 3.18 7.94%
0.75 3.45 3.25 3.01 14.90% 3.59 3.39 3.15 14.24%
0 10.25 10.25 10.25 0% 0.40 0.40 0.40 0%

0.25 10.23 10.20 10.18 0.54% 0.38 0.36 0.33 16.78%
1.1
0.50 10.20 10.14 10.09 1.06% 0.35 0.29 0.24 43.57%
0.75 10.09 10.03 10.00 0.86% 0.24 0.18 0.16 55.10%
Similar evidence is also provided by Amin, Coval, and Seyhun (2004), who find that following a
period of negative returns, implied volatilities of all options increase, with the effect more pronounced
for out-of-the-money options (see Table 6 in Section 5 for more). These findings are also in line
with cross-sectional evidence from Goyal and Saretto (2009), who find that stocks with poor recent
performance have higher option prices.17
17
On the other hand, Han (2008) finds that bearish sentiment and low past returns lead to more negative risk-neutral
skewness and steeper implied volatility smile after controlling for various variables. Similarly, Lemmon and Ni (2014)
show that the index option implied volatilities are affected by the spread between the bullish and bearish sentiment
consistently with Han (2008). However, they do not find significant effects for the previous month’s return. Using our
model’s simulated data and running regressions similar to Han (2008), we find weak and mixed results for risk-neutral
skewness. In particular, we find the effect of past returns on the risk-neutral skewness is typically statistically non-
significant, with its sign sometimes being positive and sometimes negative depending on the control variables. Given
these mixed findings, we choose not to provide this simulation analysis and do not claim that our model can explain
this aspect of data.
20

4.2 Variance Risk Premium
As demonstrated in Section 3, when stock returns exhibit stochastic volatility, extrapolating past
stock returns while forming beliefs on future returns generates bias in stock return variance expecta-
tions. Potentially, such variance bias has important implications for the risk premia that the investor
is willing to accept for bearing variance risk in the stock market. Our starting point for the variance
risk premium is the variance swap, a financial contract that allows investors to trade and specu-
late on future stock return variance. A time-t initiated τ -period variance swap is a claim to payoff
1 R t+τ
ϑu du − Υ∗t (τ ) N at its maturity date t + τ , where N is the notional amount and Υ∗t (τ ) is the

τ t
variance swap rate that is set at the contract initiation time t so that the contract has zero value.
Standard no-arbitrage arguments suggest that the variance swap rate satisfies:
h 1 Z t+τ i
Υ∗t (τ ) = E∗t ϑu du , (17)
τ t
where E∗t denotes the conditional expectation under risk-neutral measure P∗ . Consistent with the
literature (e.g., Carr and Wu (2009)), we define the variance risk premium as the difference between
the realized variance, the expected average variance over the life of the variance swap, Υt (τ ) , and
the variance swap rate, Υ∗t (τ ), where the realized variance satisfies:
h 1 Z t+τ i
Υt (τ ) = Et ϑu du , (18)
τ t
where now the conditional expectation is taken under objective measure P. Proposition 5 presents
the equilibrium variance risk premium Πt (τ ) with its key property in our stationary economy.
Proposition 5 (Equilibrium variance risk premium). In the economy with extrapolative beliefs,
the equilibrium variance risk premium is:
Πt (τ ) = Υt (τ ) − Υ∗t (τ ) , (19)
where realized variance Υt (τ ) and variance swap rate Υ∗t (τ ) are:
21

Υt (τ ) = A (τ ) + B (τ ) ϑt , (20)
Υ∗t (τ ) = A∗ (τ ) + B ∗ (τ ) ϑt + C ∗ (τ ) Xt , (21)
with !
∗ ηϑ 1 − e−κ1 τ 1 − e−κ2 τ
C (τ ) = − , (22)
κ2 − κ1 κ1 τ κ2 τ
where ηϑ is as in Proposition 3, and constants κ1 , κ2 , and the deterministic functions B ∗ (τ ), A∗ (τ ) ,

B (τ ), A (τ ) appear in the Appendix.
In the rational benchmark economy, the equilibrium variance risk premium is Π̄t (τ ) = Ῡt (τ ) − Ῡ∗t (τ ),
where realized variance Ῡt (τ ) and variance swap rate Ῡ∗t (τ ) are given by Ῡt (τ ) = Ā (τ )+B̄ (τ ) ϑ̄t and
Ῡ∗t (τ ) = Ā∗ (τ ) + B̄ ∗ (τ ) ϑ̄t , and deterministic functions B̄ ∗ (τ ), Ā∗ (τ ), B̄ (τ ), Ā (τ ) appear in the
Appendix.
Consequently, in the economy with extrapolative beliefs, the variance risk premium is increasing in
sentiment Xt but is decreasing in stock return variance ϑt .
In the rational benchmark economy, fluctuations in the realized variance and variance swap rate,
and hence in the variance risk premium, are all due to fluctuations in the stock return (conditional)
variance. In this economy, the variance risk premium is always negative, and a higher stock return
variance leads to a more negative variance risk premium. The negativity of the variance risk premium
is due to the fact that the investor is risk-averse and thus dislikes higher stock return variance,
and is willing to accept a negative stock return, on average, to hedge variance increases.18 Under
extrapolative beliefs, the realized variance is still driven only by stock return variance. However,
the variance swap rate, and thus the variance risk premium, is now additionally driven by investor
sentiment X, as (21) shows. This result arises because while adjusting for risks, the investor’s biases
are ought to be taken into account. Since investor sentiment drives variance bias, it manifests in the
variance expectation under the risk-neutral measure, and therefore in the variance swap rate, but not
in the realized variance.
18
The negativity of the average variance risk premium is well-documented in the empirical literature (see, for example,
Bakshi and Kapadia (2003), Bakshi and Madan (2006), Carr and Wu (2009), Bollerslev, Tauchen, and Zhou (2009),
Barras and Malkhozov (2016)). We note that the average variance risk premium is also negative in the steady-state of
our economy for the baseline parameter values in Table 4.
22

As a novel result, we find that a more bearish sentiment leads to a more negative variance risk
premium, thereby increasing its magnitude, C ∗ (τ ) < 0. This result arises because the investor
expects future returns to be more volatile when she has a more bearish sentiment due to her variance
bias (Proposition 3). Therefore, the variance swap contract becomes feasible only if the variance
swap rate is set higher, leading to a more negative variance risk premium.19 As discussed in the
Introduction, extant research attributes variance risk premium fluctuations to various shocks, and
thus one contribution of the current study is complementing the literature by identifying a new
economic determinant of the variance risk premium—past-return-driven investor sentiment.
The variance risk premium has recently attracted much attention in the literature because of
growing evidence that suggests it predicts future stock market returns. We now assess the predictive
power of the variance risk premium in our model. Toward that, we first consider the univariate
regression of (h-period) future stock returns ln(St+h /St ) on the (τ -horizon) variance risk premium
Πt (τ ) (i.e., ln(St+h /St ) = β0 + βΠ Πt (τ ) + t+h ) and report slope coefficient βΠ and its key property
in the steady-state of our economy in Proposition 6.
Proposition 6 (Predictive power of variance risk premium: Univariate regression). In

the economy with extrapolative beliefs, the equilibrium slope coefficient in the univariate regression of
future stock returns ln(St+h /St ) on variance risk premium Πt (τ ) is:
Cov [Πt (τ ), ln(St+h /St )]

βΠ = , (23)
Var [Πt (τ )]
where constants Cov [Πt (τ ), ln(St+h /St )] and Var [Πt (τ )] appear in the Appendix.
In the rational benchmark economy, the equilibrium slope coefficient in the univariate regression of fu-
h i
ture stock returns ln(S̄t+h /S̄t ) on the variance risk premium Π̄t (τ ) is β̄Π = Cov Π̄t (τ ) , ln S̄t+h /S̄t
h i h i h i
/Var Π̄t (τ ) , where constants Cov Π̄t (τ ) , ln S̄t+h /S̄t and Var Π̄t (τ ) appear in the Appendix.
Consequently, in the economy with extrapolative beliefs, the slope coefficient of the variance risk pre-
mium in the univariate regression is negative.
19
To the best of our knowledge, there is currently no formal empirical study showing how the investor sentiment affects
variance risk premium. However, our model prediction is in line with the evidence in Barras and Malkhozov (2016),
who find that the magnitude of the variance risk premium increases in recessions since one could argue that investors
are more likely to have a bearish sentiment during recessions.
23

The key implication of Proposition 6 is that slope coefficient βΠ is negative, implying that a more
negative variance risk premium leads to higher future stock returns, consistent with vast empirical
evidence (Bollerslev, Tauchen, and Zhou (2009), Drechsler and Yaron (2011), Bollerslev, Todorov,
and Xu (2015), Kilic and Shaliastovich (2019), Pyun (2019)). Such predictability arises in our model
because a more negative variance risk premium largely indicates a higher variance swap rate due to
more bearish investor sentiment, suggested by Proposition 5. Since bearish sentiment times coincide
with the stock price being lower than that justified by its current fundamentals, subsequent observed
stock returns become higher, on average, due to relatively higher shocks. Since the slope coefficient
indicates only the direction and economic significance of the predictive power; to conclude that the
variance risk premium can indeed predict future stock returns, we assess the statistical significance of
the slope coefficient using regression based on the model’s simulated data. Table 3, Panel A reports
average Newey-West (HAC) corrected t-statistics of the slope coefficient, along with the adjusted R2
from univariate regressions.20
Table 3, Panel A reports that in univariate predictive regressions, the slope coefficient for the
variance risk premium is more precise in the presence of extrapolative beliefs (θ > 0) than in the
rational benchmark economy (θ = 0). This result is due to the fact that the variance risk premium
isolates investor sentiment under extrapolative beliefs. As Proposition 5 shows, investor sentiment X
drives only the variance swap rate but not the realized variance, whereas conditional return variance
ϑ drives both the variance swap rate and realized variance. Variance risk premium fluctuations thus
largely derive from sentiment fluctuations rather than fluctuations in the return variance, which is
diminished by taking the difference in (19). Therefore, due to more volatile sentiment and variance
risk premium (independent variable), we obtain more precise slope coefficient estimates with lower
20
We simulate our model for varying extrapolation degree θ at a daily frequency and then extract the stock returns
and variance risk premium at the end of each month. We then run the predictive regressions with 12,000 monthly
observations. In our regressions, we set the return horizon to 3 months and the variance horizon to 1 month, consistent
with the empirical tests (e.g., Bollerslev, Tauchen, and Zhou (2009), Drechsler and Yaron (2011)). We repeat our
simulation 1,000 times and report the average quantities. Throughout our analysis, for the lag selection in the Newey-
West (HAC) corrected t-statistics, we use the recommended number of lags in Newey and West (1994). The parameter
values used in our simulation are reported in Table 4. Since we have already established the direction of the predictive
power of the variance risk premium analytically in Proposition 6, the primary role of the Table 3 to show that this
predictability is indeed statistically significant at conventional levels. For this reason, we do not report the average
estimates of the slope coefficients in this Table but do so in our quantitative analysis in Section 5.
24

Table 3: Predictive power of variance risk premium: Statistical significance. These panels report
the average Newey-West (HAC) corrected t-statistics of the slope coefficients along with the adjusted R2 in
the univariate regression of ln(St+h /St ) = β0 + βΠ Πt (τ ) + t+h (Panel A) and in the joint regression of
ln(St+h /St ) = β0 + βΠ Πt (τ ) + βΥ Υt (τ ) + t+h (Panel B), for varying levels of extrapolation degree θ across
the 1, 000 simulated paths of our economy with each path containing 12, 000 monthly observations. The return
horizon is 3 months (h = 0.25), variance horizon is 1 month (τ = 1/12), and all the other parameter values are
as in Table 4.
Panel A: Univariate regression

θ
0 0.25 0.50 0.75
t-statΠ -1.63 -3.38 -5.11 -6.97
Adj. R2 0.44% 1.08% 2.35% 4.68%
Panel B: Joint regression
θ
0 0.25 0.50 0.75
t-statΠ – -2.13 -3.56 -4.48
t-statΥ – 0.69 0.56 -0.27
Adj. R2 – 1.22% 2.48% 4.77%
standard errors. Since the predictive power of the variance risk premium is due to extrapolative
belief-induced sentiment, higher extrapolation leads to a higher magnitude for the t-statistics and
adjusted R2 s, again due to an even more volatile variance risk premium.
Table 3, Panel A also indicates that in the rational benchmark economy, θ = 0, we obtain less
precise slope coefficient estimates for the same sample. This result arises because in this economy, all
fluctuations to the variance risk premium are due to fluctuations in the stock return variance, which
primarily scales the unpredictable component of stock returns. Therefore, stock returns (dependent
variable) are more volatile relative to the variance risk premium, leading to less precise slope coefficient
estimates with higher standard errors.
Empirical evidence suggests that the variance risk premium predicts future stock market returns
in joint regressions in which the other regressor is realized variance. We next examine the predictive
power of the variance risk premium in our model by considering a joint regression of (h-period) future
stock returns ln(St+h /St ) on the (τ -horizon) variance risk premium Πt (τ ) and realized variance Υt (τ )
(i.e., ln(St+h /St ) = β0 + βΠ Πt (τ ) + βΥ Υt (τ ) + t+h ), reporting slope coefficients βΠ and βΥ and their
25

key property in the steady-state of our economy in Proposition 7.
Proposition 7 (Predictive power of variance risk premium: Joint regression). In the eco-
nomy with extrapolative beliefs, the equilibrium slope coefficients in the joint regression of future stock
returns ln(St+h /St ) on the variance risk premium Πt (τ ) and the realized variance Υt (τ ) are:
Cov[Πt (τ ), ln(St+h /St )]Var[Υt (τ )]−Cov[Υt (τ ), ln(St+h /St )]Cov[Πt (τ ),Υt (τ )]

βΠ = , (24)
Var [Πt (τ )] Var [Υt (τ )] − Cov [Πt (τ ),Υt (τ )]2
Cov[Υt (τ ), ln(St+h /St )]Var[Πt (τ )]−Cov[Πt (τ ), ln(St+h /St )]Cov[Πt (τ ),Υt (τ )]
βΥ = , (25)
Var [Πt (τ )] Var [Υt (τ )] − Cov [Πt (τ ),Υt (τ )]2
where constants Cov [Πt (τ ), ln(St+h /St )], Cov [Υt (τ ) , ln (St+h /St )], Cov [Πt (τ ) , Υt (τ )], Var [Πt (τ )],
and Var [Υt (τ )] appear in the Appendix.
In the rational benchmark economy, the joint regression of future stock returns ln(S̄t+h /S̄t ) on the
variance risk premium Π̄t (τ ) and the realized variance Ῡt (τ ) is not well-defined since Π̄t (τ ) and
Ῡt (τ ) correlate perfectly.
Consequently, in the economy with extrapolative beliefs, the slope coefficient of the variance risk pre-
mium in the joint regression is negative.
The key implication of Proposition 7 is that the slope coefficient for variance risk premium βΠ
is still negative even after controlling for realized variance.21 As with the univariate regression,
this is due to the fact that a more negative variance risk premium largely indicates a more bearish
sentiment, which is followed by higher subsequent stock returns, on average. To show that the
variance risk premium can indeed predict future stock returns in joint regression, we again examine
the statistical significance of its slope coefficient in the simulation. Table 3, Panel B reports that in
joint predictive regressions, the slope coefficient for the variance risk premium is more precise than the
slope coefficient for the realized variance, consistent with evidence from Bollerslev, Tauchen, and Zhou
(2009). This result is again due to the fact that additional fluctuations in investor sentiment make
the variance risk premium (independent variable) more volatile, which leads to more precise slope
coefficient estimates with lower standard errors. In contrast, realized variance is driven only by stock
21
On the other hand, in the rational benchmark economy, θ = 0, the variance risk premium and the realized variance
are perfectly correlated. Therefore, the joint regression is not well-defined due to the exact multicollinearity.
26

return conditional variance, which primarily scales the unpredictable component of stock returns.
Therefore, a higher realized variance leads to more volatile stock returns (dependent variable) relative
to itself (independent variable), and hence, to less precise slope coefficient estimates.
5 Quantitative Analysis
In this section, we assess the quantitative performance of our model by first determining the baseline
parameter values used during analysis. We then demonstrate that the quantitative effects of extra-
polative expectations on stock market quantities, option prices, and the variance risk premium are
economically significant. We further find that the predictive power of the variance risk premium is
stronger when the leverage effect is stronger, consistent with evidence.
5.1 Parameter Values
We begin by determining investor belief parameters α and θ. Consistent with corresponding estimates
from Barberis et al. (2015) and Cassella and Gulen (2018), we use a relative weight of α = 0.5. We
also note that our results are not sensitive to this parameter. We then set the baseline extrapolation
degree to θ = 0.25, but to understand its effects better, we also consider higher degrees of θ = 0.50
and θ = 0.75, and the benchmark value of θ = 0.
Values for the fundamental variance are based on documented variance moments in the data. We
set the persistence parameter, the fundamental variance mean reversion speed, which is also the mean
reversion speed of realized variance, to κ = 0.3567, since it corresponds to the reported first-order
auto-correlation of 0.70 for realized variance in Bollerslev, Tauchen, and Zhou (2009). We then ma-
tch the long-term mean of the fundamental variance, ζ/κ, to the reported unconditional mean of
the dividend growth rate variance of 0.11052 from Beeler and Campbell (2012), which immediately
implies that ζ = 0.0044. We simply set the correlation coefficient between the fundamental process
and its variance to ρ = 0. Given these values, we chose a fundamental variance volatility parameter,
σ, such that the volatility of the realized variance in the model is as close as possible to the corre-
sponding volatility in Bollerslev, Tauchen, and Zhou (2009), without violating our model’s parameter
27

Table 4: Parameter values. This table reports the parameter values used in our Tables.
Parameter Symbol Value

Relative weight α 0.5
Extrapolation degree θ {0, 0.25, 0.50, 0.75}
Fundamental process mean growth rate µ 0.0212
Fundamental variance mean reversion speed κ 0.3567
Fundamental variance long-run mean coefficient ζ 0.0044
Fundamental variance volatility term σ 0.1625
Correlation coefficient of fundamentals ρ 0
Interest rate r 0.0056
restriction (κ + ρσ (1 + θ))2 > σ 2 (1 + θ) (2 + θ), which ensures that the equilibrium stock price has a
real solution for all θ values we consider. This yields σ = 0.1625. Finally, we match interest rate r to
the reported average riskless rate of 0.56% from Beeler and Campbell (2012) and back out the fun-
damental process mean growth rate, µ = 2.12%, an economically plausible value, from our restriction
r − µ − ζb − rαc = 0.22 This procedure yields the parameter values reported in Table 4.
5.2 Quantitative Effects of Extrapolative Expectations
Table 5 reports the quantitative effects of extrapolative expectations in the model regarding stock
related quantities, along with corresponding evidence. The stock risk premium and volatility evidence
is from Beeler and Campbell (2012), but many other studies document similar magnitudes for these
quantities. In our model, the baseline case, θ = 0.25, generates a risk premium of 2.30% and a
volatility of 16.36%. Although the volatility value is close to the evidence, the risk premium is
significantly lower than the evidence. This finding is unsurprising since the investor has low risk
aversion (logarithmic preferences) and thus requires a low risk premium to hold the stock.23 That
22
We note that, in our simulations, we also set the initial value of the fundamental process to D0 = 100, and the
arbitrary constant a in our stock price expression (8) to 2.75, which only scales the stock price level and leads to a
plausible price-fundamental ratio S/D, without affecting the stock returns, volatility, and hence any of our main results.
23
One can generate a higher risk premium in this framework by considering more general power (CRRA) preferences.
However, our analysis shows that this comes with the cost of tractability. For example, with more general power
preferences, the fundamental variance elasticity of the stock price, b, in Proposition 1, can only be obtained numerically,
which also implies that our comparative static results in Propositions 1–2, that depend on b can no longer be obtained
28

being said, we see that extrapolation degree θ significantly affects the risk premium, and leads to
a much higher risk premium in the extrapolative beliefs economy than in the rational benchmark
economy. Evidence of the correlation (between the stock return and its variance changes) is from
Eraker and Wu (2017), which is broadly consistent with, and lies roughly in the middle of, other
estimates of this quantity in the literature, which varies from −0.40 to −0.81 (e.g., Bakshi, Cao, and
Chen (1997), Eraker, Johannes, and Polson (2003), Andersen, Benzoni, and Lund (2002), Aït-Sahalia,
Fan, and Li (2013)). According with the evidence, our framework generates large magnitudes for the
correlation between the stock return and its variance changes, ρSϑ , even when fundamental processes
are uncorrelated, ρ = 0.
Stock return bias evidence is from Greenwood and Shleifer (2014), who find that an equal share of
investors being bullish and bearish corresponds to an expectation of 8.5%, close to the average one-
year return of 8.1% on the CRSP value-weighted stock market from 1997 to 2011. We thus deduce the
mean bias to be 0.4%, a value close to the mean return bias in the baseline economy. Greenwood and
Shleifer find that a 20% increase in the stock price during the previous year (an increase of roughly one
standard deviation of returns) increases the stock return expectation by 1.8%. We use this finding,
combined with countercyclical return evidence, to infer upper and lower bounds for the return bias.
By adding (subtracting) 1.8% to (from) the mean value of 0.40%, we obtain the lower (upper) bound
for the return bias following high (low) past returns of 2.20% (−1.40%). When we conduct a similar
analysis, we find that a 20% increase (decrease) in the stock price during the previous year leads to
a return bias of 2.17% (−1.41%) in the baseline model.
Reported in Table 1 in Section 2, the literature does not provide realistic estimates of volatility
bias, but the direction of the effects of past returns on volatility expectations in our model is consistent
with findings from Graham and Harvey (2001), Amromin and Sharpe (2014), and Kaplanski et al.
(2016), and also appears to be economically significant. For example, using the baseline economy, we
find that a 20% increase (decrease) in the stock price during the previous year leads to a volatility
bias of −3.35% (1.85%).
analytically in the absence of a closed-form solution for b. To highlight our mechanisms and results in a simple and
tractable way, we refrain from considering more general preferences solely to obtain more realistic risk premium levels
in this paper.
29

Table 5: Effects for the stock: Model vs. evidence. This table reports the effects of extrapolative
expectations for the stock related quantities for varying levels of extrapolation degree θ in our model using
the parameter values in Table 4, as well as the corresponding reported empirical evidence. In the model, the
√
risk premium is given by µSt − r, return volatility by ϑt , correlation by ρSϑ , return expectation bias by
Est [dSt /St ] /dt − Et [dSt /St ] /dt, and volatility expectation bias by Est [dϑt ] /dt − Et [dϑt ] /dt. These quantities
are evaluated at the steady-state, and high (low) past returns refers to a 20% increase (decrease) in the stock
price in the previous year (roughly one standard deviation increase (decrease) in the sentiment Xt ). This
table also reports the average slope coefficient βDS along with its Newey-West (HAC) corrected t-statistics in
parentheses and the R2 in the predictive regression of (St+h − St )/St = β0 + βDS (Dt /St ) + t+h for varying
levels of extrapolation degree θ across the 1, 000 simulated paths of our economy with monthly returns with
each path lasting 62 years (as in evidence), for return horizons h = 1 year and h = 5 years. The empirical
evidence for the risk premium and the return volatility are from Beeler and Campbell (2012), correlation from
Eraker and Wu (2017), return expectation bias from Greenwood and Shleifer (2014), and the predictive power
of D/S from Cochrane (2011).
θ
0 0.25 0.50 0.75 Evidence
Risk premium 1.56% 2.30% 3.51% 7.08% 6.36%
Return volatility 12.50% 16.36% 21.07% 30.52% 16.52%
Correlation −0.46 −0.53 −0.61 −0.77 −0.61
High past returns 0 2.17% 4.51% 7.62% > 2.20%
Return bias Mean 0 0.38% 0.93% 2.24% 0.40%
Low past returns 0 −1.41% −2.66% −3.14% <−1.40%
High past returns 0 −3.35% −6.35% −8.38% −
Volatility bias Mean 0 −0.53% −1.14% −2.20% −
Low past returns 0 1.85% 2.97% 2.85% −
Predictive regression: (St+h − St )/St = β0 + βDS (Dt /St ) + t+h
βDS 6.72 8.64 9.55 10.05 3.80
h = 1 year (1.57) (2.46) (3.32) (4.48) (2.60)
R2 7.75% 11.72% 17.76% 29.96% 9%
βDS 16.49 19.31 19.27 18.34 20.60
h = 5 years (2.07) (3.41) (4.66) (6.75) (3.40)
R2 11.39% 16.29% 23.04% 38.16% 28%
Evidence of the predictive power of the fundamental-to-price ratio, D/S, is from Cochrane (2011).
By running similar predictive regressions using the model’s simulated data with each path lasting 62
years (as in Cochrane (2011)), we find that a higher D/S leads to higher future stock returns, as in
evidence. We also find the magnitudes of the slope coefficient, t-statistics, and R2 in the economy to be
30

Table 6: Effects for the options: Model vs. evidence. This table reports the effects of extrapolative
expectations for the put and call option implied volatilities for varying levels of extrapolation degree θ in our
model using the parameter values in Table 4, as well as the corresponding reported empirical evidence in Amin,
Coval, and Seyhun (2004). The option moneyness is K/St = 1 for at-the-money (ATM) put and call options,
is K/St = 0.96 for out-of-the-money (OTM) put options and K/St = 1.04 for out-of-the-money (OTM) call
options (as in evidence). Positive (negative) past returns refers to when the previous 60-days stock returns
are greater than 5% (less than −5%) (as in evidence). The option maturity is 2 months, which is roughly
the average option maturity in the sample of Amin, Coval, and Seyhun (2004). We simulate our model and
across 1, 000 simulated paths we pick the paths that satisfy the positive (negative) past return condition as in
evidence. We then, for each such path, compute the implied volatilities, and finally report the average implied
volatilities across those paths.
θ
0 0.25 0.50 0.75 Evidence
Positive past returns 11.77% 14.22% 17.31% 23.47% 17.60%
OTM
Negative past returns 15.73% 20.41% 26.42% 38.60% 21.70%
Put
ATM
OTM
Call
ATM
comparable to reported evidence. In sum, Table 5 shows that the quantitative effects of extrapolative
expectations in our model accord with empirical evidence on the stock return volatility, correlation,
return expectation bias, and the predictive power of the fundamental-to-price ratio. That being said,
due to logarithmic preferences, our model does not offer a realistic stock risk premium.
Table 6 reports the quantitative effects of past returns on option-implied volatilities in our model,
along with corresponding evidence from Amin, Coval, and Seyhun (2004, Table 4). Amin, Coval, and
Seyhun find that when the previous 60 days of stock returns are greater than 5% (less than −5%), the
put and call index option-implied volatilities are lower (higher), with the effect being more pronounced
for out-of-the-money options, in comparison to at-the-money options. They also find that following
negative past returns, implied volatilities of put options increase more than call options. Using our
31

model’s simulated data, we calculate the option prices and (Black-Scholes) implied volatilities for
simulation paths on which the previous 60 days of returns are greater than 5% or less than −5%, with
results reported in Table 6. The effects of past stock returns in our model are broadly consistent with
Amin, Coval, and Seyhun (2004) evidence.24 We also see that, our baseline economy generates more
realistic implied volatility values than the rational benchmark model does.
We next assess the quantitative performance of our model for the variance risk premium. Table 7,
Panel A reports the means of the realized variance, the variance swap rate and their difference, and
the variance risk premium in the model, along with corresponding evidence from Bollerslev, Tauchen,
and Zhou (2009).25 We see that extrapolation degree θ significantly affects the magnitudes of these
quantities. In the baseline case, θ = 0.25, the magnitudes of the realized variance and the variance
swap rate lie within their reported magnitudes, but their difference, the variance risk premium, is
much smaller than reported evidence. This lower risk premium in the model is unsurprising; it again
arises due to the representative investor having low risk aversion, requiring a lower premium not only
for the equity risk, but also for the variance risk.
Table 7, Panel B reports the predictive power of the variance risk premium and realized variance
in our model, along with corresponding evidence from Bollerslev, Tauchen, and Zhou (2009). We
use simulated data and run predictive regressions with a sample size of 18 years of monthly data,
as in Bollerslev, Tauchen, and Zhou (2009).26 These short sample regression findings corroborate
earlier results reported in Table 3, which used a much longer sample to approximate the steady-state
24
We note that since this analysis depends on simulations, in the computation of the option prices, each path uses
different values for the stock price, stock volatility, and sentiment. This methodology is different from the one employed
in Table 2 of Section 4, in which the effects of past returns on option prices are determined by controlling for the current
stock price and stock volatility but varying only the sentiment levels.
25
Following the convention in this literature, we report the variance risk premium related quantities in monthly
squared percentages. Their annualized values can be obtained by multiplying these quantities by 12/10000. Moreover,
the variance risk premium related quantities we report in Table 7 are the instantaneous quantities, corresponding to their
one-period versions commonly employed in this literature using discrete-time models, including Bollerslev, Tauchen, and
Zhou (2009). That is, the realized variance refers to Et [ϑt + dϑt /dt], the variance swap rate refers to E∗t [ϑt + dϑt /dt],
and the variance risk premium refers to their difference, Et [dϑt ]/dt − E∗t [dϑt ]/dt. These simpler instantaneous variance
quantities embed all the features of their corresponding longer τ -horizon versions that are provided in Proposition 5, and
in particular, yields identical magnitudes for their predictive power as a simple comparison of the univariate regression
results in Table 3 and Table 8 illustrates.
26
Given that the risk premium levels in our model are lower than those in data, to be able to compare the slope
coefficients arise in our model to those in data, we report the normalized slope coefficients, which show the effects of
one standard deviation increase in independent variables on future stock returns in terms of standard deviations.
32

Table 7: Effects for the variance risk premium: Model vs. evidence. This table reports the effects of
extrapolative expectations for the variance risk premium related quantities for varying levels of extrapolation
degree θ in our model using the parameter values in Table 4, as well as the corresponding reported empirical
evidence in Bollerslev, Tauchen, and Zhou (2009). Consistent with their one-period definitions in Bollerslev,
Tauchen, and Zhou (2009), in the model, the realized variance (RV) refers to Et [ϑt + dϑt /dt] = ζϑ + (1 − κ) ϑt ,
variance swap rate (VSR) refers to E∗t [ϑt + dϑt /dt] = ζϑ + (1 − κ − ρSϑ σϑ )ϑt + ηϑ Xt , and the variance risk
premium (VRP) refers to their difference, Et [dϑt ]/dt − E∗t [dϑt ]/dt = ρSϑ σϑ ϑt − ηϑ Xt . Panel A reports their
mean values in terms of monthly percentage squares, and Panel B the average normalized slope coefficients (the
effect of one std. dev. increase in regressors on std. dev. change on future returns) along with their Newey-West
(HAC) corrected t-statistics in parentheses in the predictive regressions across the 1, 000 simulated paths of our
economy with monthly returns with each path lasting 18 years (as in evidence). The predictive return horizon
is 3 months, h = 0.25.
Panel A: Variance risk premium

θ
0 0.25 0.50 0.75 Evidence
Realized variance (RV) 13.02 22.30 37.00 77.62 14.93
Variance swap rate (VSR) 14.11 23.69 40.09 93.54 33.23
Variance risk premium (VRP) −1.09 −1.39 −3.09 −15.93 −18.30
Panel B: Predictive regressions

θ
0 0.25 0.50 0.75 Evidence
Univariate regression VRP −0.11 −0.18 −0.22 −0.29 −0.15
(−0.90) (−1.50) (−1.89) (−2.45) (−2.86)
Univariate regression RV 0.11 0.15 0.20 0.28 0.00

(0.90) (1.21) (1.59) (2.28) (0.00)
VRP – −0.24 −0.25 −0.29 −0.16

(−1.26) (−1.38) (−1.19) (−2.91)
Joint regression
RV – −0.04 0.00 0.02 −0.04
(0.17) (0.34) (0.39) (−0.41)
of the model, resulting in higher magnitudes for the t-statistics. In the baseline case, θ = 0.25, one
standard deviation more negative variance risk premium leads to a 0.18 standard deviation increase
in future stock returns in univariate regression. This effect is in line with evidence, which suggests a
0.15 standard deviation increase. We also find the effects of realized variance in joint regression to be
much smaller and as in evidence—a −0.04 standard deviation. We also assess the predictive power
of realized variance using univariate regression, finding that its predictive power is less statistically
33

Table 8: Leverage effect and the variance risk premium. Panel A reports the correlation ρSϑ , and the
average Newey-West (HAC) corrected t-statistics of the slope coefficients along with the adjusted R2 in the
univariate regression of ln(St+h /St ) = β0 + βVRPt + t+h for fundamental correlation levels of ρ = 0.415 and
ρ = 0 for varying levels of extrapolation degree θ across the 1, 000 simulated paths of our economy with each
path containing 12, 000 monthly observations. The return horizon is 3 months (h = 0.25), and the VRP refers
to the instantaneous variance risk premium, Et [dϑt ]/dt − E∗t [dϑt ]/dt = ρSϑ σϑ ϑt − ηϑ Xt . Panel B reports the
average R2 of the above univariate regression across the high and low negative correlation months sub-samples
of the 1, 000 simulated paths of our economy with each path containing 27 years of monthly observations (as in
evidence), as well as the corresponding reported empirical evidence in Pyun (2019). A month is specified as a
high (low) correlation month if the magnitude of the correlation in that month belongs to the highest (lowest)
tercile of the correlation distribution in that path. All the other parameter values are as in Table 4.
Panel A: Leverage effect in our model with different fundamental correlation

θ
0 0.25 0.50 0.75
ρSϑ 0 −0.05 −0.11 −0.16
ρ = 0.415 t-statVRP − −2.23 −4.05 −5.65
Adj. R2 − 0.35% 1.04% 2.00%
ρSϑ −0.46 −0.53 −0.61 −0.77
ρ=0 t-statVRP −1.63 −3.38 −5.12 −6.98
Adj. R2 0.44% 1.08% 2.35% 4.68%
Panel B: Leverage effect and predictive power of variance risk premium in sub-samples
θ
0 0.25 0.50 0.75 Evidence
High correlation R 2 5.68% 5.55% 7.07% 10.35% 7.0%–13.9%
Low correlation R2 5.47% 5.11% 6.65% 9.81% 0.4%–4.0%
significant than that for the variance risk premium.
We next look at the relationship between the variance risk premium and the tendency of a stock
return and its volatility to move in opposite directions, often called the leverage, or volatility feedback,
effect.27 Table 8, Panel A reports the correlation between the stock return and its variance changes,
27
Our analysis here simply follows the vast literature and refers to the negative correlation between the stock returns
and its variance changes as the “leverage effect,” even though the stock in our model is unlevered. This terminology
dates back to Black (1976) and Christie (1982), who argue that the return-volatility relationship is due to the changes
in financial leverage, i.e., a lower stock price leads to a higher debt-to-equity ratio, making the stock riskier and hence
more volatile. Relatedly, the “volatility feedback effect” in the literature typically refers to the mechanism that when
the volatility risk is priced, higher expected volatility leads to a lower stock price (e.g., French, Schwert, and Stambaugh
(1987), Campbell and Hentschel (1992)). The more recent works on the leverage effect include Bollerslev, Litvinova,
and Tauchen (2006), Bandi and Renò (2012), Aït-Sahalia, Fan, and Li (2013), Carr and Wu (2017).
34

and the predictive power of variance risk premium in the model at two fundamental correlation levels.
We first set the fundamental correlation to be, ρ = 0.415, so that there is no leverage effect in the
rational benchmark (Heston) economy, ρ̄Sϑ = 0, which also implies that the instantaneous variance
risk premium is zero, with no predictive power. This case helps illustrate more clearly how the presence
of extrapolative beliefs, θ > 0, generates a leverage effect and sizable fluctuations in the variance risk
premium to predict future stock returns. We then report results for our baseline economy, in which
the fundamental correlation is zero, ρ = 0. In this case, a substantial leverage effect is evident, even in
the rational benchmark economy, due to the priced variance risk in our framework. We also see that
both the leverage effect and predictive power of the variance risk premium increase in extrapolation
degree θ. These findings accord with empirical results from Pyun (2019), who show that the predictive
power of the variance risk premium is stronger when the leverage effect is stronger.
Similar to the methodology used by Pyun (2019), we also divide simulated paths into sub-samples
of high and low correlation months and assess the predictive power of the variance risk premium in
these sub-samples. We report the R2 s of the predictive regression in Table 8, Panel B. The R2 s of
the predictive regression during high correlation months are higher than those during low correlation
months, corroborating Pyun (2019), though the magnitudes of their difference are not as large as in
the evidence.28
6 Conclusion
We develop a dynamic equilibrium model of stock return extrapolation in the presence of stochastic
stock return volatility. In the model, extrapolating past stock returns while forming expectations
on future returns also leads to biased volatility expectations. When investors expect higher (lower)
28
We obtain the reported model values in Table 8, Panel B, as follows. We first simulate our model at daily frequency
and extract the conditional correlation for each month using the daily quantities. Similar to the methodology in Pyun
(2019), we then specify a month as a high (low) correlation month if the magnitude of the correlation in that month
belongs to the highest (lowest) tercile of the correlation distribution in that path. We then run separate predictive
regressions ln(St+h /St ) = β0 + βVRPt + t+h in the sub-samples of high and low correlation months with the return
horizon of three months (h = 0.25) and 27 years of monthly observations, consistent with the sample size of Pyun (2019).
We repeat our simulation 1,000 times and report the average R2 s. The reported ranges for the evidence in Panel B
follow from Pyun (2019, Table 3) for the contemporaneous beta approach using one-month correlations and account for
different variance risk premium definitions and estimation techniques (ordinary least squares or weighted least squares).
35

returns after good (bad) stock performance, they also expect lower (higher) return volatility, consistent
with survey evidence. The model is highly tractable; it provides analytic option pricing formulas that
nest the Heston (1993) stochastic volatility formulation, offering closed-form solutions and analytical
comparative statics results for all other economic quantities. The main novel predictions of the model
are as follows. When investors’ future return expectations depend more on past returns, stock prices
become more sensitive to fundamental variance shocks, leading to stock returns that correlate more
negatively with return variance. A more bearish investor sentiment after recent bad stock performance
leads to higher put and call option prices, and price increases that are more pronounced for out-of-the-
money options. The variance risk premium is affected by investor sentiment, and it predicts future
stock market returns negatively even after controlling for realized (or conditional) variance, consistent
with empirical evidence.
When demonstrating the effects of investor sentiment on derivatives, we focus on options and
the variance risk premium, given their importance and empirical evidence from the literature. To
demonstrate economic mechanisms and asset pricing results as clearly as possible, we consider an
economy with a single investor whose beliefs reflect the consensus belief, rather than considering a more
complex heterogeneous investor economy in which only some investors are extrapolators. We thus
do not complicate analyses with endogenous wealth transfer effects, which might generate additional
effects on asset prices, but would lead to intractable, non-stationary equilibrium in a constant relative
risk-aversion framework like ours. Moreover, some of our mechanisms might appear similar to those
found in Bayesian learning models, in which investors update and increase their estimates of the
unobservable expected growth rate of a fundamental (or expected stock return) following positive
shocks. However, it is unclear whether it remains possible in learning models to obtain our variance
bias channel and reconcile somewhat puzzling evidence regarding option prices, as we do. We leave
such analyses using these features to future research.
36

Appendix: Proofs
Proof of Proposition 1. We first determine the equilibrium stock price in our economy with finite
horizon T , then by letting T → ∞, we obtain the equilibrium stock price in our stationary infinite-
horizon economy. Toward that, using the consistency relation, we first equate the stock price dynamics
s = dω − (θX /σ
under both measures (3) and (5), to obtain dω2t s
2t t S2t )dt, where ω2 is the Brownian
motion under the investor’s subjective measure Ps . This implies the likelihood ratio between the
investor’s subjective measure Ps and the objective measure P, denoted by L, as
Rt R t θXu 2
dPs θXu
0 σS2u
dω2u − 12
0 σS2u
du
Lt = |t = e , (A.1)
dP
with dynamics dLt = Lt (θXt /σS2t )dω2t , where the endogenous stock diffusion term σS2 and the
sentiment process X are as in (3) and (4), respectively.
Next, knowing that the time-T marginal utility of the investor evaluated at the aggregate con-
sumption (the stock payoff DT ) gives the equilibrium subjective state price density, denoted by ξTs , we
obtain ξTs = DT−1 . By changing the measure, we then obtain the time-T value of the objective state
price density as ξT = LT ξTs = LT DT−1 , which is posited to follow the dynamics
dξt = −ξt [rdt + m1t dω1t + m2t dω2t ] , (A.2)
where m1 and m2 are, yet to be determined, equilibrium market prices of risk for the Brownian
motions ω1 and ω2 , respectively. Substituting ξT into the no arbitrage condition for the discounted
stock price, ξt St = Et [ξT DT ], we obtain ξt St = Et [LT ] = Lt , where the last equality follows from the
fact that the likelihood ratio L is a P martingale. This implies the discounted stock price dynamics
θXt
d (ξt St ) = ξt St dω2t . (A.3)
σS2t
On the other hand, application of the Itô’s Lemma using the posited dynamics (3) and (A.2) yields
h i
d (ξt St ) = ξt St µSt − r − (σS1t m1t + σS2t m2t ) dt + (σS1t − m1t ) dω1t + (σS2t − m2t ) dω2t , (A.4)
37

and matching the diffusion terms in (A.3)–(A.4) immediately gives m1t = σS1t and m2t = σS2t −
θXt /σS2t , and the drift terms gives

2 2
µSt − r − σS1t + σS2t + θXt = 0, (A.5)
which is the condition that will be used to verify our stock price conjecture later on.
To determine the equilibrium stock price explicitly, we conjecture that it takes the form
St = Dt ea(t)+b(t)Vt +c(t)Xt , (A.6)
for some deterministic functions of time c (t), b (t), and a (t) with boundary conditions c (T ) = b (T ) =
a (T ) = 0. To verify our conjecture, we first note that (A.6) implies
d ln St = d ln Dt + ȧ (t) dt + b (t) dVt + ḃ (t) Vt dt + c (t) dXt + ċ (t) Xt dt,
√
which after substituting d ln Dt = (µ − Vt /2) dt + Vt dω1t as well as (2) and (4), becomes
1 1

d ln St = µ+ ȧ (t)+ζb (t)+ ḃ (t)− κb (t)− Vt +(ċ (t)− αc (t)) Xt dt
1 − αc (t) 2
p
1 + ρσb (t) p 1 − ρ2 σb (t) p
+ Vt dω1t + Vt dω2t . (A.7)
1 − αc (t) 1 − αc (t)
Applying Ito’s Lemma to the function ex using the dynamics (A.7), and matching its diffusion and
drift terms with the posited stock price dynamics (3), immediately gives
p
1 + ρσb (t) p 1 − ρ2 σb (t) p
σS1t = Vt , σS2t = Vt ,
1 − αc (t) 1 − αc (t)
and
1 1

µSt = µ + ȧ (t) + ζb (t) + ḃ (t) − κb (t) − Vt + (ċ (t) − αc (t)) Xt
1 − αc (t) 2
1 1 + 2ρσb (t) + σ 2 b2 (t)
+ Vt . (A.8)
2 (1 − αc (t))2
38

Therefore, our conjecture (A.6) is verified if these coefficients satisfy the equality in (A.5), that is,
h 1 1 1 + 2ρσb (t) + σ 2 b2 (t) i

0 = [ċ (t) − (1 + θ) αc (t) + θ] Xt + ḃ (t) − − κb (t) − Vt
2 2 1 − αc (t)
+ [ȧ (t) − r + µ + ζb (t) + rαc (t)] , (A.9)
which is satisfied if the three square brackets terms are all zero by the method of undetermined
coefficients. The first bracket term in (A.9) leads to the ordinary differential equation (ODE) ċ (t) =
(1 + θ) αc (t) − θ, with the boundary condition c (T ) = 0, whose solution is given by
1 − e−α(1+θ)(T −t)
c (t) = θ . (A.10)
α (1 + θ)
Note that 1 − αc (t) > 0. The second bracket term in (A.9) leads to a Riccati equation with time-
varying coefficients (due to the time variation in c (t)), and the last bracket term in (A.9) leads to the
ordinary differential equation ȧ (t) = r − µ − ζb (t) − rαc (t), which characterize the stock price.
Having verified the conjectured stock price (A.6), we next obtain the equilibrium stock price in
our stationary infinite-horizon economy as St = Dt ea+bVt +cXt , for some constants c, b, and a. This
is achieved by first setting ċ (t) = ḃ (t) = ȧ (t) = 0 in (A.9), since in the stationary equilibrium these
coefficients need to be constant. Then the first bracket term immediately yields the constant c as in
(9), which can alternatively obtained by letting T → ∞ in (A.10). After substituting c, the second
bracket term in (A.9) leads to the quadratic equation
1 1
(2 + θ) + (κ + ρσ (1 + θ)) b + σ 2 (1 + θ) b2 = 0, (A.11)
2 2
which has a real solution if
(κ + ρσ (1 + θ))2 > σ 2 (1 + θ) (2 + θ) , (A.12)
which is the restriction we specified in Section 2. Solving the quadratic equation (A.11) leads to two
roots, but only one of the roots arise as the corresponding rational benchmark economy unique root
in the limit T → ∞ when θ = 0, and we take that root to be the solution for b and report it in (10).
39

Finally, the last bracket term in (A.9) leads to the parameter restriction of r −µ−ζb−rαc = 0, for the
stock price in our infinite-horizon economy to be well-defined. This verifies the reported equilibrium
stock price in (8), and in this case, its diffusion terms are given by
p
1 + ρσb p 1 − ρ2 σb p
σS1t = Vt , σS2t = Vt , (A.13)
1 − αc 1 − αc
and its mean return by
1 1 1 1 + 2ρσb + σ 2 b2

µSt = µ + ζb − κb + Vt − αcXt + Vt , (A.14)
1 − αc 2 2 (1 − αc)2
which also imply the market prices of risk as

p
1 + ρσb p 1 − ρ2 σb p 1 − αc
m1t = Vt , m2t = Vt − p √ θXt . (A.15)
1 − αc 1 − αc 1 − ρ2 σb Vt
The equilibrium stock price in the rational benchmark economy is obtained by setting θ = 0 in
q
(8), which leads to c̄ = 0, and b̄ = −2/(κ + ρσ + (κ + ρσ)2 − 2σ 2 ).
Property (i), which states that the stock price is increasing in sentiment Xt , but is decreasing
in fundamental variance Vt , follows from the facts that c > 0 and b < 0, which are immediate from
(9)–(10). Property (ii), which states that the sentiment elasticity is increasing in the extrapolation
degree θ, but is decreasing in the relative weight α, follows from the facts ∂c/∂θ = 1/α (1 + θ)2 > 0,
and ∂c/∂α = −θ/α2 (1 + θ) < 0. Property (iii), which states that the fundamental variance elasticity
is decreasing in the extrapolation degree θ, follows from the fact that ∂b/∂θ < 0. To see this, note
2 (3+2θ)

∆2 − σ 2 (1 + θ) (2 + θ) − (2 + θ) ρσ + √2∆ρσ−σ
p
∆+
∂ 2 2 2 ∆ −σ (1+θ)(2+θ)
b=− 2 ,
∂θ
p
∆+ ∆2 − σ 2 (1 + θ) (2 + θ)
where we have defined ∆ ≡ κ + ρσ (1 + θ). Hence, ∂b/∂θ < 0 if and only if the numerator term above
is positive, which after some algebra reduces to the equivalent condition
q 1
(κ − ρσ) ∆ + ∆2 − σ 2 (1 + θ) (2 + θ) + σ 2 (2 + θ) > 0,
2
40

that always holds, since all the terms on the left hand side are positive, where the positivity of
∆ = κ + ρσ (1 + θ) is implied by (A.12) and the positivity of κ.
Proof of Proposition 2. The equilibrium stock return variance is given by ϑt = Vart [dSt /St ] /dt =
2 + σ 2 , and substituting the diffusion terms in (A.13) immediately gives it as in (11).
σS1t S2t
The equilibrium correlation between the stock return and its variance changes is given by ρSϑ =
p
Covt [dSt /St , dϑt ] / Vart [dSt /St ] Vart [dϑt ], and substituting the covariance and the variance terms
dSt 1 + 2ρσb + σ 2 b2 dSt 1 + 2ρσb + σ 2 b2 ρ + σb

Covt , dϑt = Cov t , dVt = σ Vt dt,
St (1 − αc)2 St (1 − αc)2 1 − αc
!2 !2
1 + 2ρσb + σ 2 b2 1 + 2ρσb + σ 2 b2
Vart [dϑt ] = Vart [dVt ] = σ 2 Vt dt,
(1 − αc)2 (1 − αc)2
gives the correlation as in (12).
The equilibrium stock return variance and the correlation between the stock return and its variance
in the rational benchmark economy are obtained by setting θ = 0 in (11)–(12), as it leads to c̄ = 0
q
with b̄ = −2/(κ + ρσ + (κ + ρσ)2 − 2σ 2 ).
Property (i), which states that the stock return variance is increasing in the extrapolation degree
θ follows from the fact that ∂ϑt /∂θ > 0. To see this, note that
∂ ∂ 1 + 2ρσb + σ 2 b2 ∂ h i
ϑt = V t 2 = Vt (1 + θ)2 1 + 2ρσb + σ 2 b2 ,
∂θ ∂θ (1 − αc) ∂θ
∂ ∂
1 + 2ρσb + σ 2 b2 is positive, and this is always the case since 1 + 2ρσb + σ 2 b2 =

which is positive if ∂θ ∂θ
∂
2 ρσ + σ 2 b 2
∂θ b > 0, as ρσ + σ b < 0 and ∂b/∂θ < 0.
Property (ii), which states that the correlation between the stock return and its variance is decre-
asing in the extrapolation degree θ follows from the fact that ∂ρSϑ /∂θ < 0. To see this, note
∂ ∂ ρ + σb
ρSϑ = p ,
∂θ ∂θ 1 + 2ρσb + σ 2 b2
and this is always negative since the numerator is decreasing (∂b/∂θ < 0) while the denominator is
increasing in θ.
41

Proof of Proposition 3. The equilibrium stock return variance dynamics is obtained by using the
fundamental variance dynamics (2) and (11), which yields
p q p
dϑt = (ζϑ − κϑt )dt + ρσϑ ϑt dω1t + 1 − ρ2 σϑ ϑt dω2t , (A.16)
where we have defined

s
1 + 2ρσb + σ 2 b2 1 + 2ρσb + σ 2 b2
ζϑ = ζ , σϑ = σ , (A.17)
(1 − αc)2 (1 − αc)2
and the drift term in (A.16) gives the objective expectation Et [dϑt ] /dt = ζϑ − κϑt . Substituting the
s = dω − (θX /σ
investor’s subjective Brownian motion dω2t 2t t S2t )dt into (A.16) yields
q
s
p p
dϑt = (ζϑ − κϑt + ηϑ Xt )dt + ρσϑ ϑt dω1t + 1 − ρ2 σϑ ϑt dω2t ,
where ηϑ is as in (14), and the drift term gives the subjective expectation Est [dϑt ] /dt as in (13).
The subjective expectation of the equilibrium stock return variance in the rational benchmark
economy is obtained by setting θ = 0 in the above dynamics as it leads to η̄ϑ = 0.
The property, which states that the subjective expectation of the future stock return variance is
decreasing in sentiment Xt , immediately follows from the fact that ηϑ < 0 in (14).
Lemma A1 (Equilibrium risk-neutral dynamics). In the the economy with extrapolative beliefs,
the equilibrium stock price risk-neutral dynamics is given by the system
∗
p
dSt = St rdt + ϑt dωSt , (A.18)
dϑt = (ζϑ − κ∗ϑ ϑt + ηϑ Xt ) dt + σϑ ϑt dωϑt

∗
p
, (A.19)
1 p
∗
dXt = α r − ϑt − Xt dt + α ϑt dωSt , (A.20)
2
where the constants s

1 + 2ρσb + σ 2 b2
κ∗ϑ = κ + ρSϑ σϑ , σϑ = σ , (A.21)
(1 − αc)2
with ζϑ and ηϑ are as in Proposition 3, ρSϑ is as in Proposition 2, and ωS∗ and ωϑ∗ are correlated
42

∗ dω ∗ = ρ dt.
Brownian motions under the risk-neutral measure with dωSt ϑt Sϑ
In the rational benchmark economy, the equilibrium stock price risk-neutral dynamics is given by the
q q
∗ , and dϑ̄ = ζ̄ − κ̄∗ ϑ̄ dt + σ̄ ∗ ∗

system dS̄t = S̄t r̄dt + ϑ̄t dω̄St t ϑ ϑ t ϑ ϑ̄t dω̄ϑt , where the constants κ̄ϑ =
q
κ+ ρ̄Sϑ σ̄ϑ , and σ̄ϑ = σ 1 + 2ρσ b̄ + σ 2 b̄2 , with ζ̄ϑ is as in Proposition 3, ρ̄Sϑ is as in Proposition 2, and
ω̄S∗ and ω̄ϑ∗ are correlated Brownian motions under the risk-neutral measure with dω̄St
∗ dω̄ ∗ = ρ̄ dt.
ϑt Sϑ
Proof of Lemma A1. The independent Brownian motions under the (objective) risk-neutral measure
ω1∗ and ω2∗ are given by
∗
dω1t = dω1t + m1t dt, (A.22)
∗
dω2t = dω2t + m2t dt, (A.23)
where m1 and m2 are the stationary equilibrium market prices of risk, and given by (A.15) in the
proof of Proposition 1. Substituting (A.22)–(A.23) into the objective stock price dynamics
p
1 + ρσb p 1 − ρ2 σb p
dSt = St (r + ϑt − θXt ) dt + Vt dω1t + Vt dω2t ,
1 − αc 1 − αc
and employing (A.15) and rearranging gives

p
h 1 + ρσb p ∗ 1 − ρ2 σb p ∗
i
dSt = St rdt + Vt dω1t + Vt dω2t (A.24)
1 − αc 1 − αc
Similarly, substituting (A.22)–(A.23) into the objective stock return variance dynamics (A.16) with
(A.15) and rearranging gives
q q
∗ ∗
p p
dϑt = ζϑ − σϑ ϑt ρm1t + 1 − ρ2 m 2t −κϑt dt+σϑ ϑt ρdω1t + 1−ρ2 dω2t ,
" #
θ 1+2ρσb+σ 2 b2 q
∗ ∗
p
= ζϑ −(κ+ρSϑ σϑ )ϑt + Xt dt+σϑ ϑt ρdω1t + 1−ρ2 dω2t . (A.25)
b 1 − αc
We note that the positivity of the mean reversion speed κ∗ϑ follows from
q
κ∗ϑ = κ + ρSϑ σϑ = κ + σ (ρ + σb) (1 + θ) = (κ + ρσ (1 + θ))2 − σ 2 (1 + θ) (2 + θ) > 0,
43

where the last equality follows from substituting (10) and rearranging. Finally, for simplicity, we
rewrite the risk-neutral dynamics of the stock price (A.24) and stock return variance (A.25) in terms
of the correlated Brownian motions ωS∗ and ωϑ∗ that are defined as
p
∗ 1 + ρσb ∗ 1 − ρ2 σb ∗
dωSt ≡ p dω1t + p dω2t , (A.26)
1 + 2ρσb + σ 2 b2 1 + 2ρσb + σ 2 b2
q
∗ ∗ ∗
dωϑt ≡ ρdω1t + 1 − ρ2 dω2t , (A.27)
∗ dω ∗ = ρ , where ρ
with dωSt is as in (12). Substituting (A.26)–(A.27) into (A.24)–(A.25) simply
ϑt Sϑ Sϑ
gives (A.18)–(A.19).
The equilibrium risk-neutral dynamics of the sentiment (A.20) follows immediately after substi-
√ ∗ into (4).
tuting d ln St = (r − ϑt /2) dt + ϑt dωSt
The equilibrium risk-neutral dynamics in the rational benchmark economy are obtained by setting
q
(κ + ρσ)2 − 2σ 2 , and hence

θ = 0 in (A.18)–(A.19) as θ = 0 leads to c̄ = 0 and b̄ = −2/ κ + ρσ +
q
to η̄ϑ = 0, ζ̄ϑ = ζ 1 + 2ρσ b̄ + σ 2 b̄2 , σ̄ϑ = σ 1 + 2ρσ b̄ + σ 2 b̄2 , and κ̄∗ϑ = κ + ρ̄Sϑ σ̄ϑ , where ρ̄Sϑ is as
∗ dω̄ ∗ = ρ̄ dt.
in Proposition 2, and dω̄St ϑt Sϑ
Proof of Proposition 4. We determine the equilibrium call option price using the no-arbitrage
h i
formula Ct = e−r(To −t) E∗t max {STo − K, 0} , which can be rewritten as
h i h i
Ct = E∗t e−r(To −t) STo 1{s >k} − Ke−r(To −t) E∗t 1{s >k} , (A.28)
To To
where we have defined s ≡ ln S and k ≡ ln K, and the expectations are taken under the risk-neutral
measure, under which the stock price follows (A.18) in Lemma A1. Employing the change of measure
techniques, the first expectation in (A.28) is equivalent to
h i h i
E∗t e−r(To −t) STo 1{s Q1
>k} = St Et 1{s >k} ,
To To
where the expectation on the right hand side is taken under the new measure Q1 which is related to the
risk-neutral measure P∗ such that dQ1 /dP∗ = MTo , where the likelihood process M has the dynamics
√ √
∗ with the Q Brownian motion ω 1 is given by dω 1 = dω ∗ − ϑ dt. For the second
dMt = Mt ϑt dωSt 1 S St St t
44

expectation in (A.28), for convenience, we denote the risk neutral measure Q2 ≡ P∗ . Hence we rewrite
h i h i
(A.28) as Ct = St EQ t
1
1{s >k} − Ke−r(To −t) EQ t
2
1{s >k} , which can be written equivalently as
To To
Ct = St Ψ1 (st , ϑt , Xt , t) − Ke−r(To −t) Ψ2 (st , ϑt , Xt, t) , where, for j = 1, 2, the conditional probability
h i
function Ψj (s, v, x, t) is given by Ψj (s, v, x, t) = Qj sTo ≥ k|st = s, ϑt = v, Xt = x . Moreover, when
the characteristic function
h i
ϕj (s, v, x, t; φ) = EQj eiφsTo |st = s, ϑt = v, Xt = x , (A.29)
subject to the terminal condition ϕj (s, v, x, T ; φ) = eiφs is well-defined, each conditional probability
function Ψj can be recovered from the characteristic function via the Levy inversion theorem (see, for
example, Duffie (2001)) as
1 1
Z ∞ h e−iφ ln K ϕ (s, v, x, t; φ) i
j
Ψj (s, v, x, t) = + Re dφ, (A.30)
2 π 0 iφ
with i being the imaginary unit, Re [z] is the real part of a complex number z.
To obtain the characteristic function (A.29), we first compactly write the dynamics of processes
under the measure Qj for j = 1, 2 as
j
p
dst = (r + uj ϑt ) dt + ϑt dωSt , (A.31)
j
p
dϑt = (ζϑ + ηϑ Xt − yj ϑt ) dt + σϑ ϑt dωϑt , (A.32)
j
p
dXt = α r + uj ϑt − Xt dt + α ϑt dωSt , (A.33)
where the constants u1 = 1/2, u2 = −1/2, y1 = κ, y2 = κ∗ϑ and ωϑ1 is a Q1 Brownian motion with
1 dω 1 = ρ dt, where ρ
dωSt ϑt Sϑ Sϑ
is as in Proposition 2, and ωS2 = ωS∗ and ωϑ2 = ωϑ∗ . We next employ the
transform analysis (see, Duffie, Pan, and Singleton (2000)) and consider the function for j = 1, 2,
F (s, v, x, t; φ, j) = eAj (To −t)+Bj (To −t)v+Cj (To −t)x+iφs , (A.34)
45

with Cj (0) = Bj (0) = Aj (0) = 0 so that F (s, v, x, To ; φ, j) = eiφs , and partial derivatives
h i
Ft = − Ȧj (τ ) + Ḃj (τ ) v + C˙j (τ ) x F, Fv = Bj (τ ) F, Fvv = Bj2 (τ ) F,
Fx = Cj (τ ) F, Fxx = Cj2 (τ ) F, Fs = iφF, Fss = −φ2 F,
Fvx = Bj (τ ) Cj (τ ) F, Fvs = iφBj (τ ) F, Fxs = iφCj (τ ) F,
where we denoted by τ = To − t. Then applying the Ito’s Lemma to F (st , ϑt , Xt , t; φ, j) yields
1 1
dF = Ft dt + Fv dϑt + Fvv dϑt dϑt + Fx dXt + Fxx dXt dXt
2 2
1
+Fs dst + Fss dst dst + Fvx dϑt dXt + Fvs dϑt dst + Fxs dXt dst ,
2
which after substituting the dynamics (A.31)–(A.33) and combing the same terms becomes
dF h i
= −C˙j (τ ) + ηϑ Bj (τ ) − αCj (τ ) Xt dt
F
1 1 2 2

2
+ −Ḃj (τ ) + 2uj φi − φ − (yj − ρSϑ σϑ φi)Bj (τ ) + σϑ Bj (τ ) ϑt dt
2 2
1 2 2

+ α(uj + φi)Cj (τ ) + αρSϑ σϑ Bj (τ ) Cj (τ ) + α Cj (τ ) ϑt dt
2
h i
+ −Ȧj (τ ) + ζϑ Bj (τ ) + αrCj (τ ) + rφi dt
j j
p p
+ (iφ + αCj (τ )) ϑt dωSt + σϑ Bj (τ ) ϑt dωϑt .
For F to be a martingale its drift must be zero, so we use the method of undetermined coefficients,
and set the drift term coefficients to zero, leading to the the ordinary differential equations
C˙j (τ ) = ηϑ Bj (τ ) − αCj (τ ) , (A.35)

1 1
Ḃj (τ ) = 2uj φi − φ2 − (yj − ρSϑ σϑ φi) Bj (τ ) + σϑ2 Bj2 (τ )
2 2
1
+α (uj + φi) Cj (τ ) + αρSϑ σϑ Bj (τ ) Cj (τ ) + α2 Cj2 (τ ) , (A.36)
2
Ȧj (τ ) = rφi + ζϑ Bj (τ ) + αrCj (τ ) , (A.37)
46

with Cj (0) = Bj (0) = Aj (0) = 0. Since F is a Qj martingale, we have
h i
F (st , ϑt , Xt , t; φ, j) = Et j [F (sTo , ϑTo , XTo , To ; φ, j)] = Et j eiφsTo = ϕj (st , ϑt , Xt , t; φ) ,
Q Q
where the last equality follows from (A.29). Finally, using (A.34) we obtain
ϕj (s, v, x, t; φ) = eAj (To −t)+Bj (To −t)v+Cj (To −t)x+iφs . (A.38)
On the other hand, given the call option price (15), we use the put-call parity Pt = Ct − St +
Ke−r(To −t) and obtain the put option price as in (16).
The equilibrium call and put option prices in the rational benchmark economy are obtained by
setting θ = 0 in (15)–(16). Since θ = 0 leads to C¯j (τ ) = 0, we obtain the option prices as in Heston
(1993) with the conditional probability function for j = 1, 2, is given by
1 1
Z ∞ h e−iφ ln K ϕ̄ (s, v, t; φ) i
j
Ψ̄j (s, v, t) = + Re dφ, (A.39)
2 π 0 iφ
where the characteristic function is given by ϕ̄j (s, v, t; φ) = eĀj (To −t)+B̄j (To −t)v+iφs , where the deter-
ministic functions B̄ (τ ), Ā (τ ) solve the ordinary differential equations B̄˙ (τ ) = (1/2) 2u φi−φ2 −

j j j j
ȳj − ρ̄Sϑ σ̄ϑ φi B̄j (τ ) + (1/2)σ̄ϑ2 B̄j2 (τ ) and Ā˙ j (τ ) = r̄φi + ζ̄ϑ B̄j (τ ) with B̄j (0) = Āj (0) = 0, and the

constants ū1 = 1/2, ū2 = −1/2, ȳ1 = κ, y2 = κ̄∗ϑ , where κ̄∗ϑ and σ̄ϑ are as in Lemma A1, ζ̄ϑ is as in
Proposition 3, and ρ̄Sϑ is as in Proposition 2.
Proof of Proposition 5. We first determine the (average) realized variance Υt (τ ). Using the
objective stock return variance dynamics (A.16) we have
1 − e−κ(u−t) Z u q
−κ(u−t)
e−κ(u−s) ϑs (ρdω1s +
p
ϑ u = ζϑ +e ϑt + σ ϑ 1 − ρ2 dω2s ), (A.40)
κ t

1−e−κ(u−t)
and the expectation Et [ϑu ] = ζϑ κ + e−κ(u−t) ϑt , which after substituted into (18) gives the
47

realized variance as in (20) with
!
1 − e−κτ ζϑ 1 − e−κτ
B (τ ) = , A (τ ) = 1− . (A.41)
κτ κ κτ
We next determine the equilibrium variance swap rate using (17), where the expectation is taken
under the risk-neutral measure, under which the stock return variance follows (A.19) in Lemma A1.
Since the drift terms of both the variance (A.19) and the sentiment (A.20) depend on one another,
to be able to determine the expectation straightforwardly, we first define the auxiliary process
Zt ≡ ζϑ + ηϑ Xt − (κ∗ϑ − κ1 ) ϑt , (A.42)
for some constant κ1 . The dynamics of Z then becomes dZt = ηϑ dXt − (κ∗ϑ − κ1 ) dϑt , which after
substituting the dynamics (A.19)–(A.20) and employing (A.42) becomes
1

dZt = α (ζϑ +ηϑ r) − κ2 Zt + (κ∗ϑ − κ1 ) (κ1 − α) − αηϑ ϑt dt+ηϑ α ϑt dωSt
∗
− (κ∗ϑ − κ1 ) σϑ ϑt dωϑt
∗
p p
,
2
where we have defined the constant κ2 as
κ2 ≡ κ∗ϑ − κ1 + α. (A.43)
Thus, by taking κ1 such that it solves the quadratic (κ∗ϑ − κ1 )(κ1 − α) − αηϑ /2 = 0, we obtain the
dynamics as
∗
− (κ∗ϑ − κ1 ) σϑ ϑt dωϑt
∗
p p
dZt = (α (ζϑ + ηϑ r) − κ2 Zt ) dt + αηϑ ϑt dωSt , (A.44)
whose drift term now does not depend on the variance process, which in return, due to (A.42), has
the dynamics
∗
p
dϑt = (Zt − κ1 ϑt ) dt + σϑ ϑt dωϑt . (A.45)
On the other hand, solving the quadratic equation for κ1 leads to two roots, with both roots leading
to the same variance swap rates due to their symmetric form. Therefore, we take κ1 to be the smaller
48

root, which along with (A.43) also shows κ2 is the larger root, which are given by
r r
2 2
(κ∗ϑ +α)− κ∗ϑ +α −4α κ∗ϑ + 12 ηϑ (κ∗ϑ +α)+ κ∗ϑ +α −4α κ∗ϑ + 12 ηϑ
κ1 = , κ2 = , (A.46)
2 2
with the relation κ1 < κ∗ϑ < κ2 .
The dynamics (A.44)–(A.45) lead to the solutions
Z u Z u
ϑu = ϑt e−κ1 (u−t) + e−κ1 (u−s) Zs ds + σϑ e−κ1 (u−s) ϑs dωϑs
∗
p
,
t t
α (ζϑ + ηϑ r)
Zs = Zt e−κ2 (s−t) + 1 − e−κ2 (s−t)
κ2
Z s q Z s q
+αηϑ e−κ2 (s−q) ϑq dωSq
∗
− (κ∗ϑ − κ1 ) σϑ e−κ2 (s−q) ϑq dωϑq
∗
,
t t
R u −κ (u−s) ∗
and hence to the expectations E∗t [ϑu ] = ϑt e−κ1 (u−t) + t e
1 Et [Zs ] ds, and E∗t [Zs ] = Zt e−κ2 (s−t) +

α (ζϑ + ηϑ r) 1 − e−κ2 (s−t) /κ2 , which after substituting the latter into the former yields
Z u Z u
α (ζϑ +ηϑ r) α (ζϑ + ηϑ r)
E∗t [ϑu ] = ϑt e−κ1 (u−t) + e−κ1 (u−s) ds + Zt − e−κ1 (u−s) e−κ2 (s−t) ds.
κ2 t κ2 t
Therefore, using (17) we obtain the variance swap rate as
Z t+τ
1 α (ζϑ + ηϑ r) 1 t+τ u −κ1 (u−s)
Z Z
Υ∗t (τ ) = ϑt e −κ1 (u−t)
du + e dsdu
τ t κ2 τ t t
α (ζϑ + ηϑ r) 1 t+τ u −κ1 (u−s) −κ2 (s−t)
Z Z
+ Zt − e e dsdu,
κ2 τ t t
and evaluating the simple integrals leads to

!
1 − e−κ1 τ α (ζϑ + ηϑ r) 1 1 − e−κ1 τ
Υ∗t (τ ) = ϑt + 1−
κ1 τ κ2 κ1 κ1 τ
!
α (ζϑ + ηϑ r) 1 1 − e−κ1 τ 1 − e−κ2 τ
+ Zt − − ,
κ2 κ2 − κ1 κ1 τ κ2 τ

which after substituting (A.42), κ1 κ2 = α κ∗ϑ + 21 ηϑ , and rearranging gives (21) with
49

ηϑ 1 − e−κ1 τ 1 − e−κ2 τ
C ∗(τ )= − , (A.47)
κ2 − κ1 κ1 τ κ2 τ
1 − e−κ1 τ κ∗ − κ1 1 − e−κ1 τ 1 − e−κ2 τ
B ∗(τ )= − ϑ − , (A.48)
κ1 τ κ2 − κ1 κ1 τ κ2 τ
ζϑ +rηϑ 1−e−κ1 τ κ1 1−e−κ1 τ 1−e−κ2 τ ζϑ 1−e−κ1 τ 1−e−κ2 τ
A∗(τ )= ∗ 1 1− − − + − . (A.49)
κϑ + 2 ηϑ κ1 τ κ2 −κ1 κ1 τ κ2 τ κ2 −κ1 κ1 τ κ2 τ
The equilibrium variance risk premium in the rational benchmark economy are obtained by setting
θ = 0 in (19)–(21). This leads to B̄ (τ ) = (1 − e−κτ )/κτ , Ā (τ ) = (ζ̄ϑ /κ)(1−(1−e−κτ )/κτ ), and
∗ ∗
C̄ ∗ (τ ) = 0 as η̄ϑ = 0, B̄ ∗ (τ ) = (1 − e−κ̄ϑ τ )/κ̄∗ϑ τ , and Ā∗ (τ ) = (ζ̄ϑ /κ̄∗ϑ )(1 − (1 − e−κ̄ϑ τ )/κ̄∗ϑ τ ), where
κ̄∗ϑ is as in Lemma A1, and ζ̄ϑ is as in Proposition 3.
The property, which states that the variance risk premium is increasing in sentiment Xt , but is
decreasing in the stock return variance ϑt , follows from the facts that C ∗ (τ ) < 0 and B (τ ) < B ∗ (τ ).
The negativity of C ∗ (τ ) is simply due to the fact that ηϑ < 0 in (A.47), whereas the second inequality
holds if and only if
!
1 − e−κτ 1 − e−κ1 τ κ∗ − κ1 1 − e−κ1 τ 1 − e−κ2 τ
< − ϑ − , (A.50)
κτ κ1 τ κ2 − κ1 κ1 τ κ2 τ
∗
and since κ∗ϑ < κ (see (A.21)) we have (1 − e−κτ )/κτ < (1 − e−κϑ τ )/κ∗ϑ τ , and hence a sufficient
condition for (A.50) to hold is given by
∗ !
1 − e−κϑ τ 1 − e−κ1 τ κ∗ϑ − κ1 1 − e−κ1 τ 1 − e−κ2 τ
< − − ,
κ∗ϑ τ κ1 τ κ2 − κ1 κ1 τ κ2 τ
which after rearranging in terms of simple integrals becomes
Z t+τ Z u Z t+τ Z u
1 −κ1 (u−s) −κ∗ϑ (s−t) 1
e e dsdu > e−κ1 (u−s) e−κ2 (s−t) dsdu,
τ t t τ t t
and the above inequality always holds since κ∗ϑ < κ2 .
50

Proof of Proposition 6. The slope coefficient in the univariate regression of future stock returns
ln(St+h /St ) on the variance risk premium Πt (τ ) is standard in econometric theory (see, for instance,
Ruud (2000)), and is given by (23), where the steady-state covariance between the variance risk
premium and the future stock returns, using (19)–(21), is given by
Cov [Πt (τ ) , ln (St+h /St )] = (B (τ ) − B ∗ (τ ))Cov [ϑt , ln (St+h /St )] − C ∗ (τ ) Cov [Xt , ln (St+h /St )] ,
(A.51)
and the variance of the variance risk premium, using (19)–(21), is given by
Var [Πt (τ )] = (B(τ )−B ∗ (τ ))2 Var [ϑt ]+C ∗ (τ )2 Var [Xt ] − 2(B(τ )−B ∗ (τ ))C ∗ (τ ) Cov [ϑt , Xt ] . (A.52)
To compute (A.51), we note that the first term is Cov [ϑt , ln (St+h /St )] = Cov [Vt , ln (St+h /St )] (1+
2ρσb + σ 2 b2 )/ (1 − αc)2 . We then use ln (St+h /St ) = ln (Dt+h /Dt ) + b (Vt+h − Vt ) + c (Xt+h − Xt ) ,
√
with ln (Dt+h /Dt ) = µh − 12 tt+h Vu du + tt+h Vu dω1u , to obtain
R R
Cov[Vt , ln(St+h /St )] = Cov[Vt ,ln(Dt+h /Dt )] + bCov[Vt ,(Vt+h − Vt )] + cCov[Vt ,(Xt+h − Xt )] , (A.53)
with
1 1 − e−κh
Cov [Vt , ln (Dt+h /Dt )] = − Var [Vt ] , (A.54)
2 κ
Cov [Vt , (Vt+h − Vt )] = − 1 − e−κh Var [Vt ] , (A.55)
α 1 + 2ρσb + σ 2 b2 e−κh − e−α(1+θ)h
Cov [Vt , (Xt+h − Xt )] = Var [Vt ]
2 (1 − αc)2 α (1 + θ) − κ

− 1 − e−α(1+θ)h Cov [Vt , Xt ] , (A.56)
where (A.54)–(A.55) follow from the well-known properties of the square-root process, whereas (A.56)
51

follows from the last line of the strong solution for the sentiment process given by
" #
1−e−α(1+θ)(u−t) αζ 1+2ρσb + σ 2 b2 1−e−α(1+θ)(u−t) e−κ(u−t) −e−α(1+θ)(u−t)
Xu = αr + −
α (1 + θ) 2κ (1 − αc)2 α (1 + θ) α (1 + θ) − κ
!
ρσ 1+2ρσb+σ 2 b2 e−κ(u−s) −e−α(1+θ)(u−s)
Z u
1+ρσb −α(1+θ)(u−s) p
+α + e Vs dω1s
t 2 (1 − αc)2 α (1 + θ) − κ 1 − αc
!
σ 1+2ρσb+σ 2 b2 e−κ(u−s) −e−α(1+θ)(u−s)
Z u
σb −α(1+θ)(u−s) q p
+α + e 1−ρ2 Vs dω2s
t 2 (1 − αc)2 α (1 + θ) − κ 1−αc
α 1 + 2ρσb + σ 2 b2 e−κ(u−t) − e−α(1+θ)(u−t)
+ Vt + e−α(1+θ)(u−t) Xt . (A.57)
2 (1 − αc)2 α (1 + θ) − κ
Hence, substituting (A.54)–(A.56) into (A.53) and using the identity
1 1 + 2ρσb + σ 2 b2 1

=− + κb , (A.58)
2 1 − αc 2
we obtain the first term in (A.51) as
Cov [ϑt , ln (St+h /St )] = h1 Var [ϑt ] − h2 Cov [ϑt , Xt ] , (A.59)
where the positive constants h1 and h2 are given by
1 1 1 − e−κh θ e−κh − e−α(1+θ)h 1 − e−α(1+θ)h

h1 = + , h2 = θ , (A.60)
2 1+θ κ 1 + θ α (1 + θ) − κ α (1 + θ)
and the steady-state variance of the stock return is given by
σϑ2 ζϑ
Var [ϑt ] = , (A.61)
2κ κ
which is immediate from the well-known properties of the square-root process ϑ, whose dynamics are
given by (A.16), and the steady state covariance between the stock return variance and the sentiment
is given by
σ2
ζϑ 4κϑ + ρSϑ σϑ
Cov [ϑt ,Xt ] = α , (A.62)
κ α (1 + θ) + κ
which is obtained by using the strong form solutions (A.40) and (A.57), which after substituting the
52

constants (A.21) and rearranging leads to
Z t −κ(t−s)
1 2 e − e−α(1+θ)(t−s) −κ(t−s)
Cov [ϑt , Xt ] = ασ e E [ϑs ] ds
2 ϑ 0 α (1 + θ) − κ
Z t
+αρSϑ σϑ e−α(1+θ)(t−s) e−κ(t−s) E [ϑs ] ds,
0
substituting E [ϑs ] = ζϑ /κ and evaluating the integrals yields

!
1 ζϑ 1 1 − e−2κt 1 − e−(α(1+θ)+κ)t ζϑ 1 − e−(α(1+θ)+κ)t
Cov[ϑt , Xt ] = ασϑ2 − + αρSϑ σϑ ,
2 κ α (1 + θ)− κ 2κ α (1 + θ)+κ κ α (1 + θ)+κ
which after taking the limit t → ∞ gives (A.62).
On the other hand, the second covariance term in (A.51) becomes
Cov [Xt , ln (St+h /St )] = Cov[Xt , ln (Dt+h /Dt )] + bCov[Xt , (Vt+h − Vt )] + cCov[Xt , (Xt+h − Xt )] ,
(A.63)
with
1 1 − e−κh
Cov [Xt , ln (Dt+h /Dt )] = − Cov [Xt , Vt ] , (A.64)
2 κ
Cov [Xt , (Vt+h − Vt )] = − 1 − e−κh Cov [Xt , Vt ] , (A.65)
α 1 + 2ρσb + σ 2 b2 e−κh − e−α(1+θ)h
Cov [Xt , (Xt+h − Xt )] = Cov [Vt , Xt ]
2 (1 − αc)2 α (1 + θ) − κ

− 1 − e−α(1+θ)h Var [Xt ] , (A.66)
where again the last equality follows from the last line of the strong solution for the sentiment process
(A.57). Hence, substituting (A.64)–(A.66) into (A.63) and using the identity (A.58) we obtain the
second term in (A.51) as
Cov [Xt , ln (St+h /St )] = h1 Cov [ϑt , Xt ] − h2 Var [Xt ] , (A.67)
where the steady-state variance of the sentiment, Var [Xt ], is obtained by using the diffusion terms in
the strong form solution (A.57) through a straightforward but tedious algebra, then taking its limit
53

t → ∞, which leads to
σ2
α ζϑ ϑ
+ ρSϑ σϑ
Var [Xt ] = 1 + 4κ . (A.68)
2 (1 + θ) κ α (1 + θ) + κ
Finally, substituting the steady-state moments in (A.61), (A.62), and (A.68) into (A.52) gives
Var [Πt (τ )], which along with (A.51) determines the slope coefficient (23) in closed-form.
The equilibrium slope coefficient in the univariate regression of stock returns ln(S̄t+h /S̄t ) on the
variance risk premium Π̄t (τ ) in the rational benchmark economy are obtained by setting θ = 0 in
h i
(23), since θ = 0 leads to C̄ ∗ (τ ) = 0, h̄2 = 0, and h̄1 = (1 − e−κh )/2κ, we obtain Var Π̄t (τ ) =
h i h i h i
(B̄(τ )−B̄ ∗ (τ ))2 Var ϑ̄t and Cov Π̄t (τ ) , ln S̄t+h /S̄t = (B̄(τ )−B̄ ∗ (τ ))((1 − e−κh )/2κ)Var ϑ̄t , with
h i
the steady state variance Var ϑ̄t = (σ̄ϑ2 /2κ)(ζ̄ϑ /κ), and B̄ (τ ), B̄ ∗ (τ ) are as in Proposition 5.
The property, which states that the slope coefficient of the variance risk premium in the univariate
regression is negative, follows from the fact that Cov[Πt (τ ),ln(St+h /St )] < 0. To see this, note that
the terms B (τ ) − B ∗ (τ ) and C ∗ (τ ) are negative, and the constants h1 and h2 are positive, hence
a sufficient condition for this covariance to be negative is Cov [ϑt , Xt ] < 0. Using its expression in
(A.62), we immediately see that Cov [ϑt , Xt ] < 0 if and only if (σϑ2 /4κ) + ρSϑ σϑ < 0. By substituting
ρSϑ and σϑ this condition becomes
σ 2 1 + 2ρσb + σ 2 b2 ρ + σb
2 +σ < 0.
4κ (1 − αc) 1 − αc
Further substituting the identity (A.58) into the above inequality leads to −σ (1/2 + κb) /2κ+ρ+σb <
0, which after rearranging becomes −σ/4κ + ρ + σb/2 < 0, and this inequality always holds as the
left hand side is always negative.
Proof of Proposition 7. The expressions for the slope coefficients (24)–(25) in the joint regression
of future stock returns ln(St+h /St ) on the variance risk premium Πt (τ ) and the realized variance
Υt (τ ) are standard in econometric theory (see, for instance, Ruud (2000)). The variance of the
variance risk premium Var [Πt (τ )] and the covariance between the variance risk premium and the
future stock returns Cov [Πt (τ ), ln(St+h /St )] are as in the proof of Proposition 6. On the other hand,
the variance of the realized variance, and the covariance between the variance risk premium and the
54

realized variance follow immediately from (19)–(21),
Var [Υt (τ )] = B 2 (τ ) Var [ϑt ] , (A.69)
Cov [Πt (τ ) , Υt (τ )] = B (τ ) [(B(τ )−B ∗ (τ ))Var [ϑt ] − C ∗ (τ ) Cov [ϑt , Xt ]] . (A.70)
Similarly, the covariance between the realized variance and the future stock returns, using (20), be-
comes Cov [Υt (τ ) , ln (St+h /St )] = B (τ ) Cov [ϑt , ln (St+h /St )] , which along with (A.59) immediately
gives

Cov [Υt (τ ) , ln (St+h /St )] = B (τ ) h1 Var [ϑt ] − h2 Cov [ϑt , Xt ] , (A.71)
where the positive constants h1 and h2 are as in (A.60), and the steady-state moments of Var [ϑt ] and
Cov [ϑt , Xt ] are as in (A.61) and (A.62), respectively.
The joint regression of future stock returns ln(S̄t+h /S̄t ) on the variance risk premium Π̄t (τ ) and
the realized variance Ῡt (τ ) in the rational benchmark economy is not well-defined since Π̄t (τ ) and
Ῡt (τ ) are perfectly correlated as they are given by Π̄t (τ ) = (Ā (τ ) − Ā∗ (τ )) + (B̄ (τ ) − B̄ ∗ (τ ))ϑ̄t and
h i
Ῡt (τ ) = Ā (τ ) + B̄ (τ ) ϑ̄t , implying Corr Π̄t (τ ) , Ῡt (τ ) = 1.
The property, which states that the slope coefficient of the variance risk premium in the joint re-
gression is negative, follows from the fact that Cov [Πt (τ ), ln(St+h /St )] Var [Υt (τ )]< Cov [Υt (τ ), ln(St+h /St )]
×Cov [Πt (τ ),Υt (τ )] . To see this, substituting (A.51) and (A.69)–(A.71) into this inequality leads to
(B(τ )−B ∗ (τ )) h1Var[ϑt ]−h2 Cov[ϑt ,Xt ] +C ∗ (τ ) h2 Var[Xt ]−h1 Cov[ϑt ,Xt ] Var[ϑt ]

< h1 Var [ϑt ] − h2 Cov [ϑt , Xt ] (B(τ )−B ∗ (τ ))Var [ϑt ] − C ∗ (τ ) Cov [ϑt , Xt ] ,

which after canceling out the same terms becomes C ∗ (τ ) Var [Xt ] Var [ϑt ] − Cov [ϑt , Xt ]2 < 0, which
always holds as C ∗ (τ ) is negative while the term in the bracket is positive.
55

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Stock Return Extrapolation, Option Prices,

and Variance Risk Premium

This version: March 2021

JEL Classifications: G12, G13.

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2 Economy with Extrapolative Beliefs

2.1 Survey Expectations and Past Returns

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Stock return Stock volatility

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dSt = St [µSt dt + σS1t dω1t + σS2t dω2t ] , (3)

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dXt = −αXt dt + αd ln St , (4)

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subject to her dynamic budget constraint:

dWt = (Wt − ψt St ) rdt + ψt dSt , (7)

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3 Extrapolative Beliefs Equilibrium

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Consequently, in the economy with extrapolative beliefs,

i) the stock price is increasing in sentiment Xt , but is decreasing in fundamental variance Vt ,

iii) the fundamental variance elasticity is decreasing in the extrapolation degree θ.

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where sentiment elasticity c and fundamental variance elasticity b are as in Proposition 1.

Consequently, in the economy with extrapolative beliefs,

i) the stock return variance is increasing in the extrapolation degree θ,

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Est [dϑt ] /dt = Et [dϑt ] /dt + ηϑ Xt , (13)

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4.1 Option Prices

Ct = St Ψ1 (ln St , ϑt , Xt , t) − Ke−r(To −t) Ψ2 (ln St , ϑt , Xt, t) , (15)

Pt = −St (1 − Ψ1 (ln St , ϑt , Xt , t)) + Ke−r(To −t) (1 − Ψ2 (ln St , ϑt , Xt, t)) , (16)

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Put option Call option

0 3.14 3.14 3.14 0% 3.28 3.28 3.28 0%

0 10.25 10.25 10.25 0% 0.40 0.40 0.40 0%

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where realized variance Υt (τ ) and variance swap rate Υ∗t (τ ) are:

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where ηϑ is as in Proposition 3, and constants κ1 , κ2 , and the deterministic functions B ∗ (τ ), A∗ (τ ) ,

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Proposition 6 (Predictive power of variance risk premium: Univariate regression). In

Cov [Πt (τ ), ln(St+h /St )]

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Panel A: Univariate regression

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Cov[Πt (τ ), ln(St+h /St )]Var[Υt (τ )]−Cov[Υt (τ ), ln(St+h /St )]Cov[Πt (τ ),Υt (τ )]

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5.1 Parameter Values

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Parameter Symbol Value

5.2 Quantitative Effects of Extrapolative Expectations

1 1 1 − e−κh θ e−κh − e−α(1+θ)h 1 − e−α(1+θ)h