Extreme returns and idiosyncratic risks: evidence from an emerging market

Eunyoung Cho

doi:10.1108/jdqs-09-2020-0022

Abstract

In this paper, we show that there is a negative premium for MAX stocks in the Korean stock market. However, there is no evidence that the MAX effect overwhelms the effects of idiosyncratic risk. When we control for idiosyncratic risk, the negative relationship between extreme returns and future returns is less robust. Rather, the cross-effect of the extreme returns and the idiosyncratic risk factors explains the negative premium. Furthermore, our results are not fully explained by the exposure to the market timing and economic state. Overall, both the extreme return and idiosyncratic risk effects appear to coexist in the Korean stock market, but they are not independently.

Highlights

Recent studies show that stock with the extremely positive returns in the past month (t À 1) experience negative returns this month (t). Bali et al (2011) refers to the highest daily return of each stock for the previous month as “MAX”
In this paper, we analyze the conjecture of the negative premium of extreme return and idiosyncratic risk effect
We apply and extend the argument of the previous studies that show the existence of the negative MAX premium in the stock markets

Summary

Introduction

Recent studies show that stock with the extremely positive returns in the past month (t À 1) experience negative returns this month (t). Bali et al (2011) refers to the highest daily return of each stock for the previous month as “MAX”. Bali et al (2011) refers to the highest daily return of each stock for the previous month as “MAX” They construct the decile portfolios based on MAX and show that difference between market adjusted returns for the lowest and highest MAX portfolios is 1% per month. We provide evidence that both the extreme return effects and idiosyncratic risk effects can coexist in the Korean stock market, MAX effect does not exist independently. Previous studies on the Korean stock market do not cover the co-existence of the extreme return effects and the idiosyncratic risk effects. 3. Extreme returns and idiosyncratic risks 3.1 Regression analysis We use the Fama–Macbeth methodology to investigate the negative MAX premium and the interaction effect of MAX Â idiosyncratic risk (hereafter, IRSK).

High H–L t-stat

Findings

Conclusion