Diversification Intensive of Risk Premia

Posted: 10 Mar 2014 Last revised: 22 Jun 2015

See all articles by Vasilios I. Sogiakas

Vasilios I. Sogiakas

University of Glasgow

Konstantinos Konstantaras

Heriot-Watt University - School of Management and Languages

Evangelos Vagenas-Nanos

University of Glasgow

Date Written: March 9, 2014

Abstract

A long criticism on the usefulness of the traditional CAPM model has been raised in the vast literature of arbitrage pricing models that propose several risk factors on firm fundamentals or investigate the stochastic properties of stock returns’ distributions, (Fama and French (2004)). However, our paper provides evidence of misspecification issues in the empirical formulations of most of these multifactor models. We reveal that existing self-financing strategies on size, value, momentum, liquidity and financial distress may contain residual idiosyncratic risk because of the existence of asymmetric diversification effects. Using data from the main US exchanges, there is strong evidence of over- and under-estimation of factor risk premia relevant to their intrinsic values. We propose an amended multifactor asset pricing model, the diversification risk premium model, to control for the intertemporal asymmetric idiosyncratic risk. Overall, our results suggest that portfolios formed on size and liquidity suffer from diversification asymmetries. Specifically, the size effect dies out when the asymmetric effect on idiosyncratic risk is accounted for. Moreover, investing on valued and financially distressed firms yields consistently positive returns associated with the systematic component of risk of the corresponding risk factors. Finally, there is evidence that the presence of risk factors is enhanced during periods of low inter-dependencies between securities’ returns.

Keywords: diversification risk premium, multifactor model, risk factors

JEL Classification: C22, C32, C58, C63, G11

Suggested Citation

Sogiakas, Vasilios I. and Konstantaras, Konstantinos and Vagenas-Nanos, Evangelos, Diversification Intensive of Risk Premia (March 9, 2014). Available at SSRN: https://ssrn.com/abstract=2406650 or http://dx.doi.org/10.2139/ssrn.2406650

Konstantinos Konstantaras

Heriot-Watt University - School of Management and Languages ( email )

Edinburgh EH14 4AS, Scotland
United Kingdom

Evangelos Vagenas-Nanos

University of Glasgow ( email )

Adam Smith Business School
Glasgow, Scotland G12 8LE
United Kingdom

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