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|
|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.