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P. Schneider, C. Wagner, J. Zechner, “Low Risk Anomalies?,” (working paper series)

P. Schneider, C. Wagner, J. Zechner, “Low Risk Anomalies?,” (working paper series)

Abstract: This paper shows theoretically and empirically that beta- and volatility-based low risk anomalies are driven by return skewness. The empirical patterns concisely match the predictions of our model that endogenizes the role of skewness for stock returns through default risk. With increasing downside risk, the standard capital asset pricing model (CAPM) increasingly overestimates expected equity returns relative to firms’ true (skew-adjusted) market risk. Empirically, the profitability of betting against beta/volatility increases with firms’ downside risk, and the risk-adjusted return differential of betting against beta/volatility among low skew firms compared to high skew firms is economically large. Our results suggest that the returns to betting against beta or volatility do not necessarily pose asset pricing puzzles but rather that such strategies collect premia that compensate for skew risk. Since skewness is directly connected to default risk, our results also provide insights for the distress puzzle.