Unrealistic Optimism and Asymmetry in the Pricing of Equity Tail Risk

Abstract

Unrealistic Optimism is the phenomenon whereby human beings are unreasonably optimistic about the likelihood and impact of tail events, and they incorporate information selectively to reinforce that optimistic bias. Specifically, they update their priors more frequently when presented with information that supports the optimistic bias than they do with information that contradicts it. Consequently, new information about extreme positive events is processed quickly and efficiently, but new information about extreme negative events is processed with a lag, and when it is finally processed, it is processed with an optimistic bias which prolongs the amount of time that it takes for the negative information to be fully and correctly incorporated. To test these predictions, this paper introduces a novel methodology to directly calculate the tail risk premium for individual stocks, and then uses this measure to examine the characteristics of this premium in the cross section of stock returns. Information about positive tail events seems to be quickly and relatively efficiently priced, i.e., the existence of a premium for bearing positive tail risk today has no predictive power on future returns. However, same cannot be said of the pricing of extreme negative tail events. The existence of a premium for bearing negative tail risk today is significantly associated lower returns in the future. Moreover, the greater the premium for bearing negative tail risk today, the more negative and more persistent are the future returns.