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Betting Against Correlation: Testing Theories of the Low-Risk Effect

62 Pages Posted: 8 Feb 2017 Last revised: 30 Jun 2017

Clifford S. Asness

AQR Capital Management, LLC

Andrea Frazzini

AQR Capital Management, LLC

Niels Joachim Gormsen

Copenhagen Business School

Lasse Heje Pedersen

AQR Capital Management, LLC; Copenhagen Business School - Department of Finance; New York University (NYU); Centre for Economic Policy Research (CEPR)

Date Written: January 31, 2016

Abstract

We test whether the low-risk effect is driven by (a) leverage constraints and thus risk should be measured using beta vs. (b) behavioral effects and thus risk should be measured by idiosyncratic risk. Beta depends on volatility and correlation, where only volatility is related to idiosyncratic risk. Hence, the new factor betting against correlation (BAC) is particularly suited to differentiating between leverage constraints vs. lottery explanations. BAC produces strong performance in the US and internationally, supporting leverage constraint theories. Similarly, we construct the new factor SMAX to isolate lottery demand, which also produces positive returns. Consistent with both leverage and lottery theories contributing to the low-risk effect, we find that BAC is related to margin debt while idiosyncratic risk factors are related to sentiment and casino profits.

Keywords: asset pricing, leverage constraints, lottery demand, margin, sentiment

JEL Classification: G02, G12, G14, G15

Suggested Citation

Asness, Clifford S. and Frazzini, Andrea and Gormsen, Niels Joachim and Pedersen, Lasse Heje, Betting Against Correlation: Testing Theories of the Low-Risk Effect (January 31, 2016). Available at SSRN: https://ssrn.com/abstract=2913508

Cliff S. Asness

AQR Capital Management, LLC ( email )

Two Greenwich Plaza, 3rd Floor
Greenwich, CT 06830
United States
203-742-3601 (Phone)
203-742-3101 (Fax)

HOME PAGE: http://www.aqrcapital.com

Andrea Frazzini

AQR Capital Management, LLC ( email )

Two Greenwich Plaza, 3rd Floor
Greenwich, CT 06830
United States
203-742-3894 (Phone)
203-742-3394 (Fax)

HOME PAGE: http://www.econ.yale.edu/~af227/

Niels Joachim Gormsen (Contact Author)

Copenhagen Business School ( email )

Solbjerg Plads 3
Frederiksberg C, DK - 2000
Denmark

Lasse Heje Pedersen

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

Copenhagen Business School - Department of Finance ( email )

Solbjerg Plads 3
Frederiksberg, DK-2000
Denmark

New York University (NYU) ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Centre for Economic Policy Research (CEPR) ( email )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

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