High Risk Episodes and the Equity Size Premium

75 Pages Posted: 30 Sep 2016 Last revised: 16 Dec 2016

Naresh Bansal

Saint Louis University - Department of Finance

Robert A. Connolly

University of North Carolina (UNC) at Chapel Hill - Finance Area

Chris T. Stivers

University of Louisville

Date Written: December 16, 2016

Abstract

We find that the equity size premium is pervasively positive, sizable, and statistically significant solely over periods that follow a high-risk month; defined as a month that ends with the expected market volatility being in its top quintile. Following the other lower-risk months, the size premium is essentially zero and statistically insignificant. Conditional CAPM alphas for Small-minus-Big (SMB) long/short portfolio returns also exhibit a very similar risk-based contingent variation. Concurrently, SMB returns are negative and reliably lower in the months leading up to our topquintile-volatility condition. Our results indicate a nonlinear positive intertemporal risk-return relation for the equity size premium, seemingly attributed to high-risk episodes where small-cap stocks face relatively higher market volatility-, illiquidity-, and default-risk. Our findings suggest support for: (1) Acharya-Pedersen’s (2005) implication that persistent illiquidity shocks can generate low concurrent returns and higher future returns, (2) Hahn-Lee’s (2006) and Kapadia’s (2011) view that default risk has a role for understanding the size premium, and (3) Ang et al’s (2006) view that stocks with a more negative sensitivity to market volatility innovations should have a higher risk premium.

Keywords: Equity Size Premium, SMB, Volatility Risk, Illiquidity Risk, Default Risk, Intertemporal Risk-Return Tradeoff

JEL Classification: G11, G12

Suggested Citation

Bansal, Naresh and Connolly, Robert A. and Stivers, Chris T., High Risk Episodes and the Equity Size Premium (December 16, 2016). Available at SSRN: https://ssrn.com/abstract=2845610 or http://dx.doi.org/10.2139/ssrn.2845610

Naresh Bansal

Saint Louis University - Department of Finance ( email )

John Cook School of Business
St. Louis, MO 63108
United States
314-977-7204 (Phone)

Robert A. Connolly

University of North Carolina (UNC) at Chapel Hill - Finance Area ( email )

Kenan-Flagler Business School
Campus Box 3490
Chapel Hill, NC 27599-3490
United States
919-962-0053 (Phone)
919-962-5539 (Fax)

HOME PAGE: http://itr.bschool.unc.edu/faculty/connolly

Chris T. Stivers (Contact Author)

University of Louisville ( email )

Finance Dept., College of Business
University of Louisville
Louisville, KY 40292
United States
502-852-4829 (Phone)

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