Are extreme returns priced in the stock market? European evidence

Abstract

This paper revisits some recently found evidence in the literature on the cross-section of stock returns for a carefully constructed dataset of euro area stocks. First, we confirm recent results for US data and find evidence of a negative cross-sectional relation between extreme positive returns and average returns after controlling for characteristics such as momentum, book-to-market, size, liquidity and short term return reversal. We argue that this is the case because these stocks have lottery-like characteristics, which is attractive to certain investors. Also, these stocks tend to be very volatile so that arbitrageurs are discouraged from correcting potential mispricing. As a consequence, these stocks are often overpriced and hence face lower expected returns. Second, when we control for extreme returns, the recently found negative relationship between idiosyncratic risk and future returns is less robust. In our models, after adding maximum returns, the relationship is insignificant and sometimes even positive. We also find that idiosyncratic skewness and coskewness play an important role for asset pricing, as predicted by several theoretical models.