Skewness, idiosyncratic volatility and expected returns

Skewness, idiosyncratic volatility and expected returns Public Deposited

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This dissertation examines the effect of skewness on expected returns posited by prior theoretical work. The dissertation shows that the low returns of stocks with high volatility and of Initial Public Offerings (IPOs) are the result of a preference for skewness. First, I analyze the relation between expected returns of stocks and their idiosyncratic volatility. I confirm that stocks with high idiosyncratic volatility have low subsequent returns. There is also substantial time-series co-variation between stocks with high idiosyncratic risk. An alternative measure of aggregate skewness, the cross-sectional skewness of all firms at a given point in time, helps explain both the common time-variation and the premium associated with firms with high idiosyncratic volatility. The next section extends the analysis of cross-sectional skewness to IPOs. In event time tests, IPOs only underperform if they list in times of high cross-sectional skewness. In calendar time tests, the returns of IPOs are sensitive to cross-sectional skewness after controls for size and book to market. The final section shows that proxies for technological change, such as lagged patent grant growth, predict future cross-sectional skewness. This suggests an economic interpretation of cross-sectional skewness as the result of changes in industry structure brought about by shocks such as significant technological change.

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