Reference : Retail Investors' Flight-To-Risk
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Business & economic sciences : Finance
Retail Investors' Flight-To-Risk
Lehnert, Thorsten mailto [University of Luxembourg > Faculty of Law, Economics and Finance (FDEF) > Luxembourg School of Finance (LSF) >]
[en] Previous research suggests that the cross-section of stock returns has substantial exposure to risks captured by higher moments in market returns. In particular, the market skewness risk premium is negative, statistically and economically significant, and cannot be explained by other common risk factors or firm characteristics. This is somewhat counterintuitive when one considers the usual interpretation of e.g. option-implied skewness as an indicator of jump risk or downside risk in the stock market. I find that price pressure associated with “crowded trades” of mutual funds is partly explaining the observed negative price of market skewness risk. 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 by moving in the opposite direction. Therefore, during flight-to-risk (FTR) episodes, when equity funds experience inflows and market prices are contaminated by ‘noise’, negative shifts in market skewness are due to short selling and do not necessarily reflect market participants’ fear about increased downside risk in the stock market. Therefore, stocks with a negative past skewness exposure perform well, because they positively correlate with the ‘noise’ component. As a result, while the expected market skewness risk premium is positive, the observed one is on average negative. I find that, firstly, net exchanges of equity funds are affecting the cross-section of stock returns, leading to a significant negative market skewness risk premium. Secondly, while the volatility risk premium appears to vary over time, the skewness risk premium is found to be constant. Thirdly, in line with my hypothesis, the market skewness risk premium is only significantly negative in months when retail investors transfer their money from bond funds to equity funds. Various robustness checks confirm the validity of the results. My findings also suggest that price ‘noise’ induced by uninformed trading is not vanished at the aggregate level.

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