Volatility-Dependent Skewness Preference

Abstract

In this article, the authors propose a variance-dependent explanation for the contradiction between skewness preference and low expected return concerning lottery stocks. They emphasize an overlooked aspect of skewness as a risk measure: the return uncertainty of extreme events. They show that, during periods of low market volatility, investors dislike large-skewness securities owing to a fear of uncertain results. Thus, one observes a positive relation between skewness and expected return because the security is currently undervalued. Conversely, negative associations occur in high-volatility environments. This conditional skewness–return nexus is demonstrated to possess return predictability and can help in adjusting portfolios with profitable buying and selling decisions. <b>Key Findings</b> ▪ The authors propose variance-dependent skewness to reconcile the skewness preference for lottery stocks with their actual low expected returns. ▪ They emphasize skewness as a risk measure of the return uncertainty of extreme events. ▪ The authors construct portfolios based on the return predictability of skewness conditional on volatility and show that these portfolios remain profitable after considering transaction costs and restrictions on short sales.