University of Nebraska–Lincoln Assistant Professor of Finance Scott Murray and a colleague investigate investors’ preference for assets whose returns are positively skewed, a phenomenon known as skewness preference.
Skewness preference refers to the prediction that, to entice investors to enter into investments where the probability of a large loss is high, the investment needs to be priced to yield high expected returns. On the other hand, investors are willing to accept a low expected rate of return on investments where the probability of a large loss is low.
The study empirically examines this phenomenon by forming skewness assets, which combine positions in both stocks and options in a manner designed to isolate the effect of large stock moves up or down. The skewness assets are designed to have a very large positive return if the underlying stock has a large up move, and a very large negative return if the underlying stock has a large down move.
“When the stock experiences only a small price move, the assets are designed to have a return that is very close to zero,” Murray said. “Basically, the portfolios magnify the effect of large moves in the stock’s price while mollifying the effect of small price moves.”
The study examines the monthly returns of these assets by comparing the returns of the skewness assets for stocks with high skewness (high up-move and low down-move probabilities) to the skewness asset returns for stocks with low skewness (low up-move and high down-move probabilities). The skewness of the stock’s return is estimated from option prices.
Using a monthly sample covering the period from 1996 through 2010 that includes an average of 325 optionable stocks per month, they find the skewness of the stock’s return is strongly related to the returns of the skewness assets. For high skewness stocks, the portfolios generate average returns that are relatively low. The portfolios generate average returns that are relatively high for low skewness stocks.
The pattern in returns is primarily driven by investors’ willingness to pay substantially to avoid large losses and is not driven by exposure to the market or other previously identified factors. The findings support the prediction of a preference for assets with positively skewed returns. The results suggest that investors are willing to pay substantially for insurance to protect against large portfolio losses.
The study was published in the Journal of Financial and Quantitative Analysis
in 2013. Coauthor of this study is Turan G. Bali of Georgetown University.
Research abstract located at: http://dx.doi.org/10.1017/S0022109013000410