Downside Correlation and Expected Stock Returns
47 Pages Posted: 9 Nov 2001
Date Written: March 2002
If investors are more averse to the risk of losses on the downside than of gains on the upside, investors ought to demand greater compensation for holding stocks with greater downside risk. Downside correlations better capture the asymmetric nature of risk than downside betas, since conditional betas exhibit little asymmetry across falling and rising markets. We find that stocks with high downside correlations with the market, which are correlations over periods when excess market returns are below the mean, have high expected returns. Controlling for the market beta, the size effect, and the book-to-market effect, the expected return on a portfolio of stocks with the greatest downside correlations exceeds the expected return on a portfolio of stocks with the least downside correlations by 6.55% per annum. We find that part of the profitability of investing in momentum strategies can be explained as compensation for bearing high exposure to downside risk.
Note: Previously titled Downside Risk and the Momentum Effect
Keywords: asymmetric risk, cross-sectional asset pricing, downside correlation, downside risk, momentum effect
JEL Classification: C12, C15, C32, G12
Suggested Citation: Suggested Citation