Default Risk and the Market Skewness Risk Effect

Abstract

We examine the impact of default risk on the market skewness risk effect that stocks with low market skewness risk outperform stocks with high risk documented in the previous literature. We find that the effect is strong among large, growth, and low default risk stocks, but vanishes among small, value, and high default risk stocks due to investors’ greater demand for hedging against downside risk. Our results suggest that the positive skewness preference theory is contradicted by investors’ hedging demand for high default risk stocks. The hedging hypothesis is also supported in a sample period after the 2007-2008 financial crisis.

Keywords: Asset pricing, market skewness risk, default risk

JEL Classification: G01, G12