Stock market volatility : rationality and irrationality

Abstract

In this master thesis we examine the asymmetric volatility in stock market returns, i.e. why the stock market is more volatile in down turns than in up turns. By examining the Norwegian stock market, we find no support for the feedback hypothesis and conclude that the leverage effect at best is a weak explanation for the asymmetric volatility. We suggest that combining the traditional rational explanations with a behavioral approach will give a better understanding of the asymmetric volatility. Our data analysis supports prospect theory as a reasonable explanation for the asymmetric volatility in the market. Further, we find support for a heuristic explanation based on affect, representativeness and extrapolation bias. We also find a one day disposition effect, supporting a behavioral approach.