DP9349 Skewness Risk Premium: Theory and Empirical Evidence

Author(s): Thorsten Lehnert, Yuehao Lin, Christian C Wolff
Publication Date: February 2013
Keyword(s): asset pricing, central moments, investor sentiment, option markets, risk aversion, skewness risk premium
JEL(s): C15, G12
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9349

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.