Conditional Skewness in Asset Pricing Tests

TLDR

Systematic skewness in asset returns implies that expected returns should reward this risk. The authors develop an asset pricing model that incorporates conditional skewness. The model incorporates conditional skewness into asset pricing. Conditional skewness explains cross‑sectional expected return variation, commands an average 3.60% annual risk premium, and is linked to the momentum effect, with low‑return momentum portfolios exhibiting higher skewness.

Abstract

If asset returns have systematic skewness, expected returns should include rewards for accepting this risk. We formalize this intuition with an asset pricing model that incorporates conditional skewness. Our results show that conditional skewness helps explain the cross‐sectional variation of expected returns across assets and is significant even when factors based on size and book‐to‐market are included. Systematic skewness is economically important and commands a risk premium, on average, of 3.60 percent per year. Our results suggest that the momentum effect is related to systematic skewness. The low expected return momentum portfolios have higher skewness than high expected return portfolios.