Swedroe: Predictable & Skewed Returns

December 02, 2015

  • The downside-variance-risk premium is the main component of the overall variance-risk premium. On average, more than 80% of the VRP is compensation for bearing changes in downside risk.
  • The skewness-risk premium is a priced factor with significant predictive power for aggregate excess returns.
  • There’s a positive and significant link between the downside-variance-risk premium and the equity premium, as well as a positive and significant relationship between the skewness-risk premium and the equity premium.
  • The predictive power of VRPD and SRP increases over the term structure of equity returns. This result is robust to the inclusion of a wide variety of common pricing factors, meaning it is independent from other common pricing ratios, such as the price-dividend ratio, price-earnings ratio or default spread.
  • The asymmetries are observed in “normal times.” However, the model is capable of addressing regularities that emerge from the occurrence of a rare disaster, such as the Great Recession of 2007-2009.
  • The VRP and its components are predictors of risk in financial markets. An increase in VRP or VRPD implies expectations of elevated risk levels in the future, and hence compensation for bearing that risk.
  • The “most striking outcome” was related to Federal Reserve Board announcements. For all variance-risk components, policy announcements that resolve financial or monetary uncertainty also reduce the premia.


Feunou, Jahan-Parvar and Okou contribute to the literature by providing a model that provides simple consumption and risk-based—yet insightful—economic intuitions. They show that investors are more concerned with market downturns and demand a premium for bearing that risk. In contrast, investors like upward uncertainty in the markets, and thus accept lower returns.

Furthermore, the authors’ results show that the downside-variance-risk premium (the difference between option-implied, risk-neutral expectations of market downside volatility and historical, realized downside variances) demonstrates significant predictive power (which is at least as powerful as the variance-risk premium, and often stronger) for excess returns.

Finally, the authors also show that the difference between upside- and downside-variance-risk premia—a proposed measure of the skewness-risk premium—is both a priced factor in equity markets and a powerful predictor of excess returns.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.


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