Left-tail risk and UK stock return predictability: Underreaction, overreaction, and arbitrage difficulties

Abstract

Recent studies challenge the standard model risk-return trade-off by showing inverse predictive power of firm-specific left-tail risk for future returns (i.e., left-tail momentum). In this work, we investigate the pricing of left-tail risk in UK stocks. Both the portfolio construction approach and Fama-MacBeth regressions reveal the underperformance of stocks with high left-tail risk. We examine alternative channels behind this pricing anomaly, namely, investor underreaction behaviour, continuous overreaction behaviour, and limits to arbitrage. Our findings suggest that the observed underperformance associated with high left-tail risk is largely a manifestation of investor underreaction to bad performance. However, the results also show that the predictable underperformance of high left-tail risk stocks is manifest in past winners. The empirical investigation reveals that, in addition to underreaction, limits to arbitrage interacts with investor high attention levels to explain part of the anomaly. The empirical findings provided here suggest several important implications for practitioners in the equity market.