Working Papers

Working Papers

1. Aretz, Kevin, and Y. Eser Arisoy, Do Stock Markets Really Care About Skewness?

Prior studies show that statistical forecasts of a stock's return skewness price stocks, apparently consistent with recent theoretical work predicting that long-term investors care about long-ahead skewness. Deviating from theory, the studies, however, use estimates of a stock's short-ahead (as, e.g., daily) return skewness, despite short-ahead return skewness having no obvious relation to long-ahead return skewness. In our paper, we follow Neuberger (2012) and Neuberger and Payne (2018) to calculate a stock's realized long-ahead return skewness. We show that the statistical estimates of short-ahead return skewness used in prior studies have close to zero power to forecast realized long-ahead skewness. We also decompose the statistical estimates of short-ahead return skewness into a component capturing long-ahead return skewness and an orthogonal component, showing that -- if anything -- it is the orthogonal component that produces the significant pricing of the skewness estimates in asset pricing tests.

2. Aretz, Kevin, Ian Garrett, and Adnan Gazi, The Early Exercise Risk Premium.

Prior studies use American option data in European option valuation theories, justifying this behavior by arguing that the ability to early exercise an option is likely to have an only minor effect the option's returns. We examine this claim using put options. We show that neoclassical finance theory predicts that American put options have significantly larger (i.e., less negative) expected returns than European put options, with the gap widening with a higher option moneyness, a lower option time-to-maturity, and a higher underlying asset (idiosyncratic) volatility. In our empirical work, we contrast the mean returns of single-stock American put options with those of "equivalent" synthetic single- stock European put options, using put-call parity on American call options written on stocks not paying out cash to calculate the European put option returns. Our results suggest that the American options have both statistically and economically larger mean returns than the equivalent European options, with the difference in mean returns relating to the stock and option characteristics as predicted by neoclassical finance theory.

3. Aretz, Kevin, Hening Liu, Shuwen Yang, and Yuzhao Zhang, Consumption Risk and the Cross-Section of Option Returns.

Long-run risk models relying on Epstein and Zin's (1989) recursive utility and allowing for macroeconomic regimes imply that consumption growth as well as its expectation and volatility price assets. While these models have many desirable features (e.g., they produce a realistic equity premium), it is a major challenge to precisely estimate the risk premiums of the three consumption risks. We present theoretical work showing that options are likely to be more suitable than other (non-derivative) assets to precisely estimate the consumption risk premiums since option returns are cleaner reflections of changes in the expectation and the volatility of consumption growth. Motivated by our theoretical results, we test the long-run risk model on delta-hedged options and straddles, finding that consumption growth and expected consumption growth is significantly positively priced and consumption volatility is significantly negatively priced. Our evidence suggests that long-run risk investors prefer early resolution of uncertainty. Our evidence further provides rational foundations for well-known "anomalous" relations between option moneyness or idiosyncratic stock volatility and delta-hedged option returns.

4. Aretz, Kevin, and Shuwen Yang, Switching Perspective: Corporate Distress, Asset and Financial Risk, and the Cross-Section of Corporate Bond Returns (***BRAND-NEW: First version***).

Many studies show that high distress-risk stocks deliver lower future returns that low distress-risk stocks ("distress anomaly"). The most promising explanation for that result so far is Garlappi et al.'s (2008) shareholder advantage theory, which argues that shareholders' ability to extract economic rents from debtholders in distress lowers the expected return of high distress-risk stocks. In our paper, we present evidence suggesting that, analogous to the often negative distress risk-stock return relation, there is also a negative relation between distress risk and the cross-section of corporate bond returns. The negative distress risk-bond return relation is robust to the timing of our distress risk proxy, the portfolio weighting scheme, and controlling for other pricing factors . Our findings constitute a serious blow to the shareholder advantage theory, which, as we show, cannot produce a negative distress premium in bonds. We further report that variables suggested by that theory fail to condition the distress risk-bond return relation. We finally offer evidence that real options models predicting high distress-risk firms to have low expected asset returns due to them owning negative-risk disinvestment options are more promising to explain the negative stock and bond distress risk premiums, with variables suggested by these theories often conditioning the premiums at statistically significant levels.