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Moment Risk Premia and Stock Return Predictability

Published online by Cambridge University Press:  26 November 2020

Zhenzhen Fan Open the ORCID record for Zhenzhen Fan [Opens in a new window] ,
Xiao Xiao  and
Hao Zhou
Zhenzhen Fan
Affiliation:
University of Manitoba Asper School of Businesszhenzhen.fan@umanitoba.ca
Xiao Xiao*
Affiliation:
University of Amsterdam Amsterdam Business School
Hao Zhou
Affiliation:
Tsinghua University PBC School of Financezhouh@pbcsf.tsinghua.edu.cn
*
x.xiao@uva.nl (corresponding author)
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Abstract

We study the predictive power of option-implied moment risk premia embedded in the conventional variance risk premium. We find that although the second-moment risk premium predicts market returns in short horizons with positive coefficients, the third-moment (fourth-moment) risk premium predicts market returns in medium horizons with negative (positive) coefficients. Combining the higher-moment risk premia with the second-moment risk premium improves the stock return predictability over multiple horizons, both in sample and out of sample. The finding is economically significant in an asset-allocation exercise and survives a series of robustness checks.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 57 , Issue 1 , February 2022 , pp. 67 - 93
Copyright
© The Author(s), 2020. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

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Footnotes

We are grateful to Hendrik Bessembinder (the editor) and David Schreindorfer (the referee) for extremely helpful guidance and suggestions. We thank Bakshi Gurdip, Bing Han, Anthony Neuberger, Cisil Sarisoy, Paul Schneider, George Tauchen, Fabio Trojani, Grigory Vilkov, Dacheng Xiu, Lai Xu, Nancy Xu, and Lu Zhang for helpful comments. We would also like to thank seminar participants at the 2018 China International Conference in Finance, Erasmus University Rotterdam, 2017 European Finance Association Annual Conference, 2017 Asian Finance Association Annual Conference, Peking University Guanghua School of Management, and Tsinghua University PBC School of Finance. A previous version of this article has been circulated under the title “Variance Risk Premium, Higher-Order Risk Premium, and Expected Stock Returns.” All remaining errors are our own.

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