Abstract
This paper proposes a framework that decomposes the market risk into three components: upside, downside, and tail risk. Their risk premiums can be estimated using information from either the index options market or the stock market. The estimated premiums from both markets share two important properties: 1) The tail risk is highly priced; 2) Once the tail risk is excluded, the downside risk is barely priced. We also observe an important difference between the two markets: While the two sides of the market are priced highly asymmetrically in the index options market with all the equity premium attributed to the downside and none to the upside, the upside risk and downside risk both contribute significantly to explaining the cross-section of stock returns. Overall, our findings shed new light on the pricing of systemic risks and provide important evidence for market segmentation.
Published Version
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