A Note on Stein’s Overreaction Puzzle

in Decisions in Economics and Finance (in press)

Recently, Christoffersen et al. (2013) argue that the overreaction puzzle of Stein (1989) can be explained by a variance-dependent pricing kernel. In this note, we challenge this view. Our theoretical ... [more ▼]

Recently, Christoffersen et al. (2013) argue that the overreaction puzzle of Stein (1989) can be explained by a variance-dependent pricing kernel. In this note, we challenge this view. Our theoretical results are in line with their argument that the variance under risk-neutral measure is more persistent than the variance under physical measure due to a negative variance risk premium. But our results do not support their argument that the more persistent variance is able to qualitatively explain Stein’s findings. We show theoretically that the persistence of the volatility cannot amplify the movements of long-term variance to short-term fluctuations in variance, and, therefore, conclude that Stein’s overreaction puzzle is still unsolved. [less ▲]

Why is the Market Skewness-Return Relationship Negative?

Scientific Conference (2020, January 23)

The observed negative relationship between market skewness and excess return or the negative price of market skewness risk in the cross-section of stock returns is somewhat counterintuitive when we ... [more ▼]

The observed negative relationship between market skewness and excess return or the negative price of market skewness risk in the cross-section of stock returns is somewhat counterintuitive when we consider the usual interpretation of e.g. option-implied skewness as an indicator of jump risk or downside risk. One possible explanation for this inconsistency is that there are factors affecting option-implied market skewness other than jump risk in the stock market. In this paper, I find that price pressure associated with “crowded trades” of mutual funds is an important endogenous factor. Given that retail investors are prone to herding, the directional trading of mutual funds is correlated, and their collective actions can generate short-term price pressure on aggregate stock prices. Short sellers systematically exploit these patterns not only in the equity lending market, but also in the options market. In line with this economic channel, I find that firstly, the significant negative relationship between market skewness and returns becomes insignificant, once I control for price pressure. Secondly, the negative relationship is only present for the “bad” downside component of risk-neutral skewness, associated with out-of-the-money put options. For the “good” upside component of risk-neutral skewness, associated with out-of-the-money call options, the relationship is always positive. Thirdly, price pressure affects the skewness-return relationship, which can be clearly distinguished from the impact of flows on the volatility-return relationship in terms of the leverage effect. [less ▲]

Why is the Market Skewness-Return Relationship Negative?

Scientific Conference (2019, December 13)

The observed negative relationship between market skewness and excess return or the negative price of market skewness risk in the cross-section of stock returns is somewhat counterintuitive when we ... [more ▼]

The observed negative relationship between market skewness and excess return or the negative price of market skewness risk in the cross-section of stock returns is somewhat counterintuitive when we consider the usual interpretation of e.g. option-implied skewness as an indicator of jump risk or downside risk. One possible explanation for this inconsistency is that there are factors affecting option-implied market skewness other than jump risk in the stock market. In this paper, I find that price pressure associated with “crowded trades” of mutual funds is an important endogenous factor. Given that retail investors are prone to herding, the directional trading of mutual funds is correlated, and their collective actions can generate short-term price pressure on aggregate stock prices. Short sellers systematically exploit these patterns not only in the equity lending market, but also in the options market. In line with this economic channel, I find that firstly, the significant negative relationship between market skewness and returns becomes insignificant, once I control for price pressure. Secondly, the negative relationship is only present for the “bad” downside component of risk-neutral skewness, associated with out-of-the-money put options. For the “good” upside component of risk-neutral skewness, associated with out-of-the-money call options, the relationship is always positive. Thirdly, price pressure affects the skewness-return relationship, which can be clearly distinguished from the impact of flows on the volatility-return relationship in terms of the leverage effect. [less ▲]

THE MARKET SKEWNESS-RETURN RELATIONSHIP, Plenary Talk

Scientific Conference (2019, September 25)

WHY IS THE MARKET SKEWNESS-RETURN RELATIONSHIP NEGATIVE?

Scientific Conference (2019, July 09)

Price Pressure and the Market Skewness Risk Premium

E-print/Working paper (2019)

Skewness Risk Premium: Theory and Empirical Evidence

in International Review of Financial Analysis (2019), 63

Using an equilibrium asset and option pricing model in a simple economy under jump diffusion, we show theoretically that the aggregated excess market returns can be predicted by the skewness risk premium ... [more ▼]

Using an equilibrium asset and option pricing model in a simple 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 risk aversion, investors demand lower risk compensation, thus substantially weakening the skewness-risk-premium-return trade off. [less ▲]

Asset Pricing Implications of Good Governance

in PLoS ONE (2019), 14 (4)(e0214930), 1-14

Corporate Governance and Skewness in Stock Returns

E-print/Working paper (2019)

This paper analyzes the relationship between corporate governance and idiosyncratic skewness of stock returns. We test this hypothesis by analyzing the impact of external as well as internal governance ... [more ▼]

This paper analyzes the relationship between corporate governance and idiosyncratic skewness of stock returns. We test this hypothesis by analyzing the impact of external as well as internal governance provisions, and are thus able to provide an overall understanding of the relationship between governance and firm-specific return asymmetries. Our results show that better governance leads to a reduction in idiosyncratic skewness in relatively non-competitive industries. In relatively competitive industries, governance has less to no impact on firm-specific return skewness. Furthermore, an overall increase in transparency, quality and disclosure of information, proxied through the Sarbanes Oxley Act, reduces relative idiosyncratic skewness. Our findings can be regarded as detrimental for shareholders, who have a preference for positive idiosyncratic skewness. The evidence contributes to a debate, which suggests that – at the end of the day – an act like Sarbanes-Oxley, which was intended to protect shareholders from accounting errors and frauds and to improve the accuracy of corporate disclosures, comes at the expenses of shareholders. The reduction of idiosyncratic skewness through better governance collides with shareholder’s preference for idiosyncratic and positively skewed stock returns, which present a lottery like upside option of monetary gains and value creation through the right tail. This side effect of governance is also in line with the literature that highlights potential costs of corporate governance. [less ▲]

Islamic Finance and Economic Growth: New Evidence

Scientific Conference (2019, January 24)

While extensive work has shown that conventional banking development is generally conducive to economic growth, there are only a limited number of studies that investigate the impact of Islamic banking ... [more ▼]

While extensive work has shown that conventional banking development is generally conducive to economic growth, there are only a limited number of studies that investigate the impact of Islamic banking. Importantly, the literature on conventional banking claims that a reverse causality from economy performance to banking may exists, but existing studies on Islamic banking fail to address this potential endogeneity problem. This paper tackles this problem and explores the relationship between Islamic banking development and economic performance in a sample of 32 developed and developing countries based on data spanning the 2000 to 2016 period. The findings show that, although Islamic banks are considered small relative to the total size of the financial sector, Islamic banking is positively correlated with economic growth even after controlling for financial structure, macroeconomic factors and other variables. The outcome is robust across different econometric specifications like pooling OLS, fixed effects, panel data with over-identified GMM, and dynamic difference GMM. The results are confirmed on two different indicators of Islamic banking and hold for different time periods. [less ▲]