Market Risk and Speculation Factors

Abstract

We decompose the excess market return into speculation and non-speculation components. The former is negative and predicted by market sentiment. The latter is positive and not predicted by sentiment. The speculation component explains roughly 30% of the variation in the excess market return. In the cross-section, the decomposition helps identify the risk and mispricing components of CAPM anomalies. Although the Fama-French factors comove with the market factor, this comovement is due to the speculation component. The decomposition resolves an anomaly pertaining to investor lottery preference. The decomposition also reconciles and unifies conflicting evidence on the pricing of left-tail risk.

Keywords: Stock Market Anomalies, Risk Premium, Speculation Premium, Left-tail Risk

JEL Classification: D8, G40, G41