Conditional Skewness of Aggregate Market Returns

Abstract

The characteristics of the distribution of security returns, such as skewness, play a significant role in financial theory and practice. This paper examines whether conditional skewness of daily aggregate market returns is predictable and investigates the economic mechanisms underlying this predictability. In both developed and emerging markets, there is strong evidence that lagged returns predict skewness; returns are more negatively skewed following an increase in stock prices, and returns are more positively skewed following a decrease in stock prices. The empirical evidence shows that the traditional explanations, such as the leverage effect, the volatility feedback effect, the stock bubble model (Blanchard and Watson, 1982), and the fluctuating uncertainty theory (Veronesi, 1999), are not driving the predictability of conditional skewness at the market level. The relation between skewness and lagged returns is more consistent with the Cao, Coval, and Hirshleifer (2002) model. Hong and Stein (2003) model predict a relation between turnover and skewness. We find some weak evidence that in developed countries, high trend-adjusted turnover predicts more negative skewness in returns. Our findings have implications for future theoretical and empirical models of time-varying market returns.

Keywords: Conditional skewness, conditional volatility, predicting skewness and volatility, aggregate market returns, international finance

JEL Classification: G12, C1