(September 3, 2013) – Investors’ perceptions of risks are totally mismatched with actual risks, driven by a lack of information during weekends and holidays.
A whitepaper entitled “Fear and Information” by Israeli scholars Guy Kaplanski and Haim Levy found interruptions to the flow of information significantly increased investors’ fear, which was found to be highest on Monday morning when markets reopen.
It then decreases until its lowest point on Thursdays, before rising again slightly on Fridays.
However, when analyzing the average trading volume of options, exactly the opposite pattern appears: perceived volatility is at its lowest on Mondays, increases until Thursday and slightly decreases on Friday.
And the longer the trading break, the longer the time during which excessive perceived risk prevails: the same results are also shown for holidays and, to a lesser extent, after overnight trading breaks.
“This trading break effect is not explained by actual price volatility, and is neither caused by economic fundamentals nor due to technical and statistical biases related to implied volatility calculation methods,” the report’s authors said.
Why the discrepancy? A lack of newsflow. “The interruption to the flow of information during trading breaks leads to excess perceived risk when the market reopens which, in turn, encourages discretionary option liquidity traders to postpone trading, resulting in lower volume,” the report continued.
“The flow of information during trading reduces this excess perceived risk, resulting in increased trading volume over the week, caused by traders who have delayed their trades.”
The lack of public information released during trading breaks leads to investor uncertainty, and therefore higher perceived risk. At the same time, discretionary options liquidity traders postpone trading until new public information arrives.
But the lack of private information, usually associated with individual companies, is also a factor. Institutional investors, for example, may collect data and have superior estimates for the most up-to-date released unemployment data, the inflation rate, and so on—which can affect the level of fear they feel about investing, the report said.
To read the full paper click here.
Related Content: Risk Management 2.0 and Risks? What Risks?