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Volatility-Dependent Skewness Preference

Xiang Gao, Kees G. Koedijk and Zhan Wang
The Journal of Portfolio Management November 2021, jpm.2021.1.295; DOI: https://doi.org/10.3905/jpm.2021.1.295
Xiang Gao
is an associate professor at the Research Center of Finance at the Shanghai Business School in Shanghai, China
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Kees G. Koedijk
is a professor of Banking and Finance at the School of Economics at Utrecht University in Utrecht, the Netherlands, and CEPR in London, UK
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Zhan Wang
is an assistant professor at the Research Center of Finance at the Shanghai Business School in Shanghai, China
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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.

Key Findings

  • ▪ 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.

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The Journal of Portfolio Management: 48 (8)
The Journal of Portfolio Management
Vol. 48, Issue 8
Emerging Markets 2022
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Volatility-Dependent Skewness Preference
Xiang Gao, Kees G. Koedijk, Zhan Wang
The Journal of Portfolio Management Oct 2021, jpm.2021.1.295; DOI: 10.3905/jpm.2021.1.295

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Volatility-Dependent Skewness Preference
Xiang Gao, Kees G. Koedijk, Zhan Wang
The Journal of Portfolio Management Oct 2021, jpm.2021.1.295; DOI: 10.3905/jpm.2021.1.295
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