The Pricing of Risk-Neutral Systematic Moments in the Cross-Section of Expected Returns

Abstract

This study investigates if changes in risk-neutral systematic volatility, skewness, and kurtosis, are priced, either symmetrically or asymmetrically, as systematic risk factors in the cross-section of stock returns. The moments are constructed using options on the S&P 500, and represent investors' expectation of the distribution of future market returns. Portfolio analyses reveal positive changes in implied market skewness are priced between -5% to -11% annually, while negative changes in implied market skewness are not priced. Additionally, when accounting for an asymmetric relation between returns and implied market skewness, changes in implied market volatility and kurtosis are not priced. The results are robust to portfolio weighting, market capitalization, book-to-market equity ratio, idiosyncratic volatility, and idiosyncratic skewness. Time-series and cross-sectional analyses confirm the portfolio results and associate positive changes in implied market skewness with a negative price of risk. An implied market skewness tracking portfolio possesses a great deal of power to price a variety of portfolio returns, and subsumes other typical hedge portfolios used in asset pricing. The results present a challenge to the theoretical asset pricing models, since the asymmetric results cannot be accounted for in an ICAPM framework, and the pricing of only positive skewness changes is inconsistent with the predictions of prospect theory.