Working Paper: CEPR ID: DP9349
Authors: Thorsten Lehnert; Yuehao Lin; Christian C. Wolff
Abstract: Using an equilibrium asset and option pricing model in a production economy under jump diffusion, we show theoretically that the aggregated excess market returns can be predicted by the skewness risk premium, which is constructed to be the difference between the physical and the risk-neutral skewness. In an empirical application of the model using more than 20 years of data on S&P500 index options, we find that, in line with theory, risk-averse investors demand risk-compensation for holding stocks when the market skewness risk premium is high. However, when we characterize periods of high and low risk aversion, we show that in line with theory, the relationship only holds when risk aversion is high. In periods of low riskaversion, investors demand lower risk compensation, thus substantially weakening the skewness-risk-premium-return trade off.
Keywords: Asset Pricing; Central Moments; Investor Sentiment; Option Markets; Risk Aversion; Skewness Risk Premium
JEL Codes: C15; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| skewness risk premium (C46) | market excess returns (G19) |
| risk aversion (D81) | market excess returns (G19) |
| high skewness risk premium (C46) | increased market excess returns (G14) |
| low risk aversion (D81) | diminished relationship between skewness risk premium and market excess returns (D81) |