Decomposed Higher-Moment Risk Premiums and Market Return Predictability

Abstract

In an empirical study of Standard & Poor's 500 index options, this paper analyses the predictability of future market excess returns by means of decomposed higher-moment risk premiums. The study proposes a new measure of kurtosis risk premium and suggests a decomposition of higher-moment risk premiums up to the fourth moment into downside and upside premiums. Thereby, the paper enhances the understanding of higher-moment risk premiums. The decomposition uncovers valuable information for return forecasts, as decomposed higher-moment risk premiums deliver improved in-sample predictions. In an out-of-sample study, the predictive power of decomposed higher-moment risk premiums is shown to be particularly driven by downside higher-moment risk premiums.

Keywords: Moment risk premiums; Kurtosis risk premium; Decomposition; Downside and upside; Predictive regressions

JEL Classification: G10, G12, G13, G17