Leverage constraints or preference for lottery: What explains the low-risk effect in India?
Shilpa Peswani and Mayank Joshipura (2021). Leverage constraints or preference for lottery: What explains the low-risk effect in India?. Investment Management and Financial Innovations, 18(2), 48-63. doi:10.21511/imfi.18(2).2021.05
17 Pages Posted: 22 Apr 2021
Date Written: April 16, 2021
The study empirically investigates two theories that claim to explain the low-risk effect in Indian equity markets using a universe of stocks listed on the National Stock Exchange of India (NSE) from January 2000 to September 2018. Leverage constraints and preference for the lottery are two major competing theories that explain the presence and persistence of the low-risk effect. While the leverage constraints theory argues that systematic risk drives low-risk anomaly and therefore risk should be measured using the beta, lottery demand theory claims that irrational investor’s preference towards stocks with lottery-like payoffs is responsible for the persistence of the low-risk effect, and risk should be measured by idiosyncratic volatility. However, given that most of the risk measures are highly correlated, it is not easy to precisely measure a specific theory’s contribution to explaining the low-risk effect. The study constructs the Betting against correlation (BAC) factor to measure the contribution of leverage constraints to the low-risk effect. It further constructs the SMAX factor to untangle the contribution of lottery preference theory. The results show that leverage constraints theory predominantly explains the low-risk effect in Indian markets. This study contributes significantly to the body of literature, as this is the first such study on the Indian market, one of the major emerging markets, especially when the debate on theories explaining the low-risk effect is yet to settle.
Keywords: betting against beta (BAB), betting against correlation (BAC), MAX, asset pricing, low-risk anomaly, beta, idiosyncratic volatility, skewness of returns
JEL Classification: G11, G12, G14
Suggested Citation: Suggested Citation