Extreme returns in emerging stock markets: evidence of a MAX effect in South Korea

Abstract

We investigate the significance of extreme positive returns (MAX) in the cross-sectional pricing of stocks in South Korea. Our results provide important out-of-sample evidence of a strong negative MAX effect similar to that documented by Bali et al. (2011) in the US stock market. For equal-weighted portfolios, the difference between returns on the portfolios with the highest and lowest maximum daily returns is −1.87% per month. The corresponding difference in alpha is −1.41% per month. The results are robust to controls for size, value, skewness, momentum, short-term reversal and idiosyncratic volatility. We also sort the portfolios by the average of the five highest daily returns within the month and report return and alpha spreads of −2.21% and −2.01% per month, respectively. However, unlike in Bali et al. (2011), the MAX effect cannot reverse the idiosyncratic volatility effect in the South Korean stock market. Our results imply investor preference for high-MAX stocks, consistent with cumulative prospect theory (CPT) where investors sub-optimally overweight the possibility that extreme returns will persist. The MAX effect is also consistent with the optimal expectations framework where investors derive utility from overestimating the probabilities of events in which their investments pay off well.