Beta and Coskewness Pricing: Perspective from Probability Weighting

Abstract

The security market line is often flat or downward-sloping. We hypothesize that probability weighting plays a role and that one ought to differentiate between periods in which agents overweight extreme events and those in which they underweight them. Overweighting inflates the probability of extremely bad events and demands greater compensation for beta risk. Underweighting has the opposite effect. Overall, these two effects offset each other, resulting in a flat or slightly negative return--beta relationship. Similarly, overweighting the tails enhances the negative relationship between return and coskewness, whereas underweighting reduces it. We support our theory through an extensive empirical study.

Keywords: Probability weighting, Beta, Coskewness, Asset Pricing

JEL Classification: G4, G12