Implied Systematic Moments and the Cross-Section of Stock

Returns

R. Jared DeLisle
Department of Finance and Management Science
Washington State University

James S. Doran
Department of Finance
Florida State University

David R. Peterson
Department of Finance
Florida State University

Draft: November 4, 2010

Corresponding author: Jared DeLisle

Department of Finance and Management Science
College of Business
Washington State University
14204 NE Salmon Creek Ave.
Vancouver, WA 98686
Email: j.delisle@wsu.edu

Electronic copy available at: http://ssrn.com/abstract=1706249

 Implied Systematic Moments and the Cross-Section of Stock Returns

Abstract

Using the risk-neutral volatility and skewness computed from options on the S&P500, we show
there is an asymmetric contemporaneous relation between stock returns and changes in implied
market volatility and skewness. Changes in expected market volatility and skewness are cross-
sectionally priced only when implied market volatility or skewness increases. All stocks have
similar returns when implied systematic volatility and/or skewness are decreasing. The economic
impact of stocks' sensitivities to changes in expected market skewness is almost twice as much as
sensitivities to changes in expected market volatility. These findings highlight the importance of
not only implied systematic volatility to investors, but also the sensitivity to changes in implied
systematic skewness.

JEL classification: G11; G12; G14

Keywords: Asset pricing; Implied market skewness; Implied market volatility; Risk neutral
market moments; Portfolio selection

Electronic copy available at: http://ssrn.com/abstract=1706249

1. Introduction

The widely used Sharpe (1964) and Lintner (1965) capital asset pricing model (CAPM) is

derived from Markowitzs (1952) mean-variance capital market theory. A common criticism of

two-moment pricing models is that they are based on the assumption that asset returns are

normally distributed, with no skewness. Arditti (1967) and Scott and Horvath (1980), however,

show that investors prefer positive skewness. Skewness in asset returns is empirically observed

in many markets (see, e.g., Mandelbrot (1963), Ane and Geman (2000), Harvey and Siddique

(2000), Aparicio and Estrada (2001), and Chung, Johnson and Schill (2006)). Extending the

traditional CAPM, Rubenstein (1973) and Kraus and Litzenberger (1976) develop a three-

moment market equilibrium model that demonstrates systematic skewness is a relevant factor in

pricing securities.

Implied stock return moments from option prices may provide information to investors.

If Black (1975) and Manaster and Rendleman (1982) are correct in their proposition that

investors in the option market are well-informed, then the distribution of returns described by

implied moments should contain information ex-ante that predicts ex-post equity return

performance.1 There are numerous studies that demonstrate the ability of implied volatility, as

well as more recently, that implied skewness has a strong predicative component for equity

returns. Bates (1991, 2000), Jackwerth and Rubinstein (1996), and Pan (2002) explain why the

implied distribution is negatively skewed and fat-tailed, linking the shape of the implied

distribution to investor risk premiums for jump and volatility. Jackwerth and Rubinstein (1996),

in particular, suggest that at-the-money (ATM) implied volatilities are systematically higher than

1
Manaster and Rendleman (1982), Easley, O'Hara and Srinivas (1998), and Chakravarty, Gulen and Mayhew (2004)

find that the option market has useful information about equity markets.

1
realized volatilities, which is related to investors aversion to volatility, prompting Banerjee,

Doran and Peterson (2007) to link implied volatility to future equity returns. Additionally, by

examining the shape of the volatility skew, Bali and Hovakimian (2009), Cremers and

Weinbaum (2010), Xing, Zhang and Zhao (2010), and Doran and Krieger (2010) all demonstrate

that information contained in option volatility skews reveals a predictive element into the future

performance of underlying stocks. These findings suggest a strong inherent price premium

reflected in the higher-order moments of the implied distribution.

Investors may want to structure their portfolios based on anticipated changes in the

market variance and skewness. Campbell (1993, 1996) and Chen (2003) modify Mertons (1973)

Intertemporal Capital Asset Pricing Model (ICAPM) and demonstrate that investors can interpret

a market volatility increase as a decrease in their investment opportunity set. Risk-averse

investors should hedge against future volatility changes by purchasing stocks that are positively

correlated with aggregate volatility innovations since market returns and volatility are negatively

correlated. Bakshi and Kapadia (2003) observe that because of the negative correlation between

returns and volatility, stocks that heavily load on market volatility provide insurance against

downward market movements. As noted by Ang, Hodrick, Xing and Zhang (2006), investors

may prefer stocks with greater sensitivity to market volatility changes since market declines are

often associated with greater volatility; stocks that do well when volatility increases may be

especially valuable because they improve portfolio performance in adverse states. Stocks that

are highly sensitive to market volatility changes may face increased demand as expectations of

market volatility increase, causing these stocks to have high returns contemporaneous with the

expectations of heightened volatility.

2
 According to Rubenstein (1973), Kraus and Litzenberger (1976), and Barberis and Huang

(2008), investors prefer positive skewness in their portfolio. In a similar argument as Ang et al.

make with market volatility, with expectations of increased market skewness, stocks with greater

sensitivity to market skewness may face increased demand, causing contemporaneously high

returns. This preference for skewness may be why we observe investors having a preference for

stocks with lottery type features, as show in Kumar (2009). Skewness could be considered a

proxy for jump risk, and investors bid up the prices of these stock hoping for a large positive

shock.

With both moments, however, it is not clear if stock return responses should be

symmetric to positive and negative changes. Black (1976) notes there is an asymmetric volatility

phenomenon where an increase in implied volatility leads to a decline in returns that is greater in

absolute magnitude than the increase in returns from a decrease in implied volatility of the same

size.2 Adrian and Rosenberg (2008) use an asymmetric volatility model to investigate effects of

market volatility on the cross-section of returns, but employ historic instead of implied volatility.

Dennis, Mayhew and Stivers (2006) allow for stock returns to respond asymmetrically to implied

volatility shocks. They find that individual stock returns are more strongly related to innovations

in implied market volatility than to changes in implied idiosyncratic volatility. This means that

market volatility innovations may be priced in the cross-section differently for upward and

downward movements. This is confirmed in DeLisle, Doran and Peterson (2010), who find that

expected stock returns are asymmetrically related to changes in the VIX index, a measure of

expected market volatility. It is fair to assume that market skewness is priced asymmetrically as

well since, like volatility, skewness mean reverts through time and is distributed evenly around

the mean.
2
See Bekaert and Wu (2000) for a summary of earlier studies on asymmetric volatility using historical data.

3
 The purpose of this study is to explore stock return patterns linked to contemporaneous

changes in expectations of market volatility and skewness, contingent on positive or negative

second and third moment innovations. Specifically, we use procedures developed by Bakshi,

Kapadia and Madan (2003) to develop measures of implied market volatility and skewness.

Then we examine the cross-sectional relation of security sensitivities to changes in implied

market volatility and skewness with stock returns. While previous empirical studies such as

Kraus and Litzenberger use historical market skewness, we use a novel approach of applying

implied market skewness derived from the options market. Implied moments should be superior

to historical moments, since implied moments are forward-looking and historical moments are

backward-looking.3 Documenting the relations between stock returns and higher implied

moments will help portfolio managers structure their portfolios, for either speculative or hedging

purposes, conditional on their views of how expectations of market volatility and skewness will

change in the future.

Employing portfolio sorting, accompanied by modified Fama and French (1993) three-

factor model regressions, and firm-level Fama and MacBeth (1973) regressions, we find an

asymmetric response of stock returns to their sensitivities to market volatility and skewness.

Specifically, responses differ cross-sectionally only when market volatility and skewness are

increasing. When the moments decrease the response is relatively uniform across all stocks.

This study is developed in the following sections. Section 2 describes the data and the

measurement of the implied moments. Section 3 details the construction of the factor loadings.

3
The predictive power of implied volatility is examined in multiple studies. For example, Christensen and Prabhala

(1998) find that the volatility implied by S&P 100 index option prices outperforms past volatility in forecasting

future index volatility. Doran and Ronn (2005) note that this estimate is biased and may be related to the volatility

risk premium.

4
In section 4 we explain the methodology behind the portfolio analysis and regressions. Section 5

presents empirical results and section 6 concludes.

2. Implied Moment Measurement

The sample is from January 1996 through December 2007. Monthly stock prices,

returns, and share volume are from the Center for Research in Security Prices (CRSP). Only

stocks with CRSP share codes 10, 11, and 12 are included. The share volumes for NASDAQ

stocks are divided by two to adjust for double-counting trades. The market risk premium

(MKT), Fama and French (1993) size and book-to-market factors (SMB and HML), risk-free

rate, and NYSE size breakpoints are provided by Kenneth Frenchs website.1 SPX option prices

are from Optionmetrics.

COMPUSTAT provides data for book equity and leverage. Book equity is the value of

stockholders equity plus all deferred taxes and investment tax credit, minus the value of any

preferred stock. The book-to-market equity ratio assigned to a firm from July of year to June

of year +1 is the book equity at the end of the fiscal year in calendar year -1 divided by the

market capitalization at the end of December of year -1. Similarly, leverage in year is defined

as the value of the total assets of the firm divided by the book equity, where both total assets and

book value of equity are calculated at the end of the fiscal year in calendar year -1. Only firms

with positive book equity are included. In order to avoid any COMPUSTAT firm bias, firms

with less than two years of data on COMPUSTAT are removed from the sample. Pastor and

Stambaugh (2003) liquidity factors are from Wharton Research Data Services (WRDS).

Allowing S(t) to be the stock index price at time t and q(S(t+)) to be the risk-neutral

density for the stock index price at time t+, the risk-neutral valuation for a call is:

5
 (1)

(2)

where C(t, ; K) is the price of a call option on the market index at time t with a maturity of

years and a strike price of K, r is the annualized risk-free rate, and E* is the risk-neutral

expectation. An analogous integral can be made for the price of a put, P(t, ; K), whose risk-

neutral valuation is: .

We are interested in the second and third moments of the risk-neutral density, for which

Bakshi, Kapadia and Madan (2003) (BKM) provide a direct, model-free approach of estimating.

Using the concept presented by Bakshi and Madan (2000) that any payoff function can be

spanned by a continuum of out-of-the-money (OTM) European puts and calls, BKM show that

the risk-neutral volatility and skewness can be expressed as functions of quadratic and cubic

payoffs, where the payoffs are the underlying stocks continuously compounded return raised to

the second and third power, respectively. BKM demonstrate that these payoffs can be expressed

as a linear combination of the OTM option prices and, as a result, so can the risk-neutral

volatility and skewness. We present this demonstration in the Appendix.

From the appendix, we employ the risk-neutral variance (VAR) and skewness (SKEW)

using options on the S&P 500 which expire in month t+1. We take the square root of VAR to

form VOL, or the risk-neutral volatility. Similar to the VIX index, VOL and SKEW have an

autoregressive component to them, and as such require differencing. As monthly changes in the

risk-neutral moments are the desired independent variables, we define the change in a respective

moment in month t as the innovation of that moment from the end of month t-1 to the end of

month t. We denote changes in the risk-neutral volatility and skewness as VOL and SKEW,

respectively.

6
 Table 1 displays the summary statistics of the levels and changes of the risk-neutral

moments, as well as the Fama and French (1993) factors. The statistics in Panel A show the

S&P 500 has negative skewness. Over our sample period, VOL has a slightly positive mean

and median while SKEW has a small negative mean and positive median. Both VOL and

SKEW exhibit substantial variability through time. Monthly correlations in Panel B show that

VOL and MKT are strongly inversely related; this is not unexpected. SKEW is not highly

correlated with any of the other variables, including VOL. Bayesian Information Criteria (BIC)

indicate that VOL and SKEW follow moving average processes, and thus are weakly

stationary and suitable for use in OLS regressions. In Figures 1 and 2 we show changes in risk-

neutral volatility (VOL) and skewness (SKEW), respectively. SKEW has large changes,

both positive and negative, toward the end of the sample period.

3. Construction of Adjusted Factor Loadings on VOL and SKEW

To isolate the effect of VOL and SKEW on returns, we orthogonalize the market

factor, MKT, to the change in the moments. We consider this essential to remove the effect of

the risk-neutral moments from MKT. As seen in Table 1, MKT is highly negatively correlated

with VOL and somewhat negatively correlated with SKEW.

We orthogonalize the traditional market factor MKT to changes in the risk-neutral

moments by regressing MKT on VOL and SKEW and use the residual in month t plus the

intercept to form MKT. By orthogonalizing MKT to VOL and SKEW, we remove the

expected market variance component related to the changes in the risk-neutral moments from the

market returns and isolate it in VOL and SKEW. MKT is decomposed into two parts which

7
are due to the changes in risk-neutral moments and an uncorrelated residual plus intercept

component. The coefficient on MKT thus measures the effect on returns from the portion of the

market factor unrelated to VOL and SKEW.

The first step to empirically obtain factor loadings is to regress individual monthly stock

returns, in excess of the risk-free rate, on MKT,VOL and SKEW. By separating the

moment changes into positive and negative variables, firms are allowed to have differing

relations with positive and negative changes in the moments. The regression is specified as:

(3)

where ri,t is the excess return for firm i in month t, MKTt is the excess return of the CRSP value-

weighted index in month t that is orthogonal to VOL and SKEW, VOL+ t is the innovation in

VOL from the end of month t-1 to the end of month t when VOL is positive and zero otherwise,

VOL- t is the innovation in VOL from the end of month t-1 to the end of month t when VOL is

negative and zero otherwise, SKEW+ t is the innovation in SKEW from the end of month t-1 to

the end of month t when SKEW is positive and zero otherwise, SKEW- t is the innovation in

SKEW from the end of month t-1 to the end of month t when SKEW is negative and zero

otherwise, and i,t is an error term. This rolling regression is estimated for each firm for June of

year over 54 months ending in December of year -1. We require at least 36 months of data

and, thus, the earliest regressions end in December, 1999. The beta estimates for each June of

year are assigned to July of year through June of year +1. The analysis begins with July,

2000.

Although each firms parameter estimates are held constant for twelve-month periods,

they are used to create adjusted factor loadings (AFLs) for changes in the moments each month

8
using the realized value of the changes for each respective month from July of year through

June of year +1. The computation of VOL AFLs is:

if VOL is greater than zero in month t or (4)

if VOL is less than zero in month t (5)

where AFLVOL,i,t is the AFL representing the marginal effect of VOL for the returns of stock i

for month t. For example, the regression may be estimated for one firm over 54 months from

June, 2001, to December, 2005, and the resulting parameter estimates ( and ) for

June, 2006, are assigned to the firm from July, 2006, through June, 2007. The AFL for July,

2006, uses the assigned parameter estimate corresponding to the sign of VOL that is realized

for July, 2006. The AFLs for August, 2006, through June, 2007, are similarly calculated, using

the same and used for the AFL computation in July, 2006, but using the

respective actual positive or negative change for each month. The same method is used to

compute the AFLs for SKEW for each firm.

4. Portfolio Formation and Regression Analysis

Each month we form portfolios of stocks by sorting them into quintiles based on the

estimated AFLs of interest (either or ). We examine the

contemporaneous returns across the quintile portfolios to determine if the AFLs are of first order

importance in explaining the differences in portfolio returns. Much of our analysis that follows

is based on zero-cost portfolios formed from differences in returns between the fifth and first

quintiles. If the zero-cost portfolio constructed by going long in high AFL stocks and short in

low AFL stocks has zero mean returns, then the AFLs do not have an impact on the stocks

9
return process. However, if a zero-cost portfolio produces a return significantly different from

zero, then the AFLs could be the source of the differences in returns.

We estimate a variation of the traditional Fama and French (1993) three-factor model to

assess if the zero-cost portfolio returns are associated with risk factors:

(6)

where rp,t is the zero-cost portfolio return for portfolio p. Equation (6) examines if MKT and

the Fama and French (1993) factors SMB and HML can explain the returns generated by zero-

cost portfolios constructed by the rankings of or . If this model does

not sufficiently describe the portfolio returns (the model generate significant alphas), than the

returns associated with sensitivity to market volatility or skewness are separate from standard

risk factors.

Finally, we estimate monthly Fama and MacBeth (1973) cross-sectional regressions with

firm-level data in order to ascertain if AFLs on VOL and SKEW matter in the cross-section

of returns. This method allows all firms to be analyzed, rather than just portfolios of high- and

low-loading stocks. The independent variables consist of the AFLs on VOL and SKEW,

MKT beta, log of size, the ratio of book-to-market equity (B/M), momentum, and liquidity beta.

The size of the firm is determined in June of calendar year and assigned to the firm from July

of calendar year to June of year +1. The B/M of each firm is the book value at the fiscal year-

end in calendar year -1 divided by the market capitalization at the end of December of year -1,

and assigned to the firm from July of calendar year to June of calendar year +1. Momentum is

the cumulative return from the end of month t-6 through the end of month t-2 prior to the month t

cross-sectional regression. The liquidity beta is estimated from a firm-level time-series

regression of returns on the three Fama and French (1993) factors plus the Pastor and Stambaugh

10
(2003) liquidity factor. This rolling regression is estimated for June of year over 54 months

ending in December of year -1. We require at least 36 months of data. The liquidity beta is

then assigned to the firm from July of calendar year to June of calendar year +1. Consistent

with the earlier portfolio analysis, the first monthly cross-sectional regression is for July, 2000.

We employ Newey and West (1987) standard errors in the construction of t-statistics.

5. Empirical Results

5.1 Portfolio Returns and VOL and SKEW

The characteristics of the quintile portfolios single-sorted by AFLs on VOL and

SKEW are reported in Panel A of Tables 2 and 3, respectively. The sorts produce smaller firms

in the lowest and highest quintiles. The B/M values of the portfolios based on VOL AFL sorts

increase monotonically form 0.70 in the lowest quintile to 0.79 in the highest quintile. The B/M

values of the portfolios based on SKEW AFL sorts range from 0.73 to 0.79, and are not

monotonic across the portfolios. Overall, the B/M ratios for the ten portfolios are very similar.

In a manner similar to Ang et al. (2006), we first present portfolio performance results

before forming size and B/M sorted portfolios. Equal and value-weighted returns are computed

for the five quintiles of VOL AFLs and reported in Panel A of Table 2. Panel A includes all

90 months of the sample, from July 200 to December 2007, and shows that a zero-cost portfolio

of going long quintile five stocks and shorting quintile one stocks (hereafter such a portfolio is

called a 5-1 portfolio) yields equal-weighted returns insignificantly different than zero.

However, the value-weighted return of the 5-1 portfolio is 1.19 percent per month and significant

at the 5 percent level. The alpha from the modified Fama and French (1993) three-factor model

11
displayed in equation (6) (henceforth the ortho FF-3 alpha) is positive and significant for both

the equal- and value-weighted portfolios.

Next we examine if the VOL portfolio returns are asymmetric conditional on the

direction of VOL. In Panels B and C of Table 2, the equal- and value-weighted returns of the

5-1 portfolios are tabulated conditional on the contemporaneous VOL. When VOL is

positive, all ten portfolio returns are negative. The equal-weighted 5-1 return is positive but

insignificant, while the value-weighted portfolio is positive and significant at the 5 percent level.

The ortho FF-3 alphas are much smaller than the 5-1 returns and insignificant, suggesting that

the AFLs matter but that their effects are subsumed by the three factors. When VOL is

negative, all ten sorted portfolios have monthly returns of at least 2.06%. There is little return

discrepancy across the portfolios and the 5-1 returns and alphas are statistically insignificant.

There is a strong positive return to all stocks, irrespective of loadings, when VOL falls. Thus,

there is evidence of asymmetry in firms returns with respect to risk-neutral volatility. AFLs on

VOL matter when market volatility increases, but not when it falls.

Panel A of Table 3 presents the equal- and value-weighted returns of the quintile

portfolios sorted by the SKEW AFLs. Over the entire 90-month sample period, the mean

equal-weighted 5-1 portfolio return is 0.52 percent and is statistically significant at the 5 percent

level. The mean value-weighted 5-1 return is 0.74 percent and is significant at the 10 percent

level. When the sample is limited to the 46 months when SKEW is positive, as shown in Panel

B of Table 3, all except the lowest quintile have positive equal-weighted returns, but all of the

value-weighted portfolio returns are negative. This indicates that size has a large impact on the

portfolio returns. The mean equal-weighted 5-1 return is 1.08 percent per month and is

significant at the 1 percent level. The average value-weighted 5-1 portfolio return is 1.40 percent

12
per month and is significant at the 5% level. The ortho FF-3 alpha for the equal-weighted 5-1

portfolio is 0.57 percent per month and significant at the 10 percent level. The value-weighted

ortho FF-3 alpha is not statistically significant, however. For equal-weighted portfolios,

SKEW AFLs affect returns beyond the influence of the three risk factors.

Panel C of Table 3 presents the quintile portfolio returns then SKEW is negative. The

quintile portfolio returns, both equal- and value-weighted, are large and of similar magnitude.

Thus, the 5-1 portfolio returns are small and insignificant in both weighting schemes. The ortho

FF-3 alphas are also small and not statistically different from zero. Similar to VOL, there is

evidence that firms relation with SKEW is asymmetric, with SKEW AFLs related to returns

after controlling for risk factor only when the market moment change is positive. The large

returns across all portfolios when SKEW is negative may be related to the average VOL

during these months (untabulated) also being negative. As seen in Panel C of Table 2, when

VOL is decreasing there are very large positive returns. Thus, an average decrease in VOL can

be associated with an average increase in returns across all stocks. Possible interactions such as

this highlight the importance of examining portfolio returns while controlling for each of the

variables in order to disentangle the effects of VOL and SKEW.

5.2 Portfolio Returns from Double-Sorts on Factor Loadings

Next, we examine whether sorting on VOL AFLs is important after controlling for

SKEW AFLs, and whether sorting on SKEW AFLs is important after controlling for VOL

AFLs. Each month the sample is independently sorted into quintiles based on the VOL and

SKEW AFLs. To examine the effect of VOL loadings across each of the five SKEW

quintiles, we average returns across SKEW quintiles for each VOL quintile. This provides for

13
returns across VOL AFL quintiles while controlling for SKEW AFLs. To examine the effect

of SKEW loadings across each of the five VOL quintiles, we average returns across SKEW

quintiles for each VOL quintile. This provides for returns across SKEW AFL quintiles while

controlling for VOL AFLs. Since results in Tables 2 and 3 show no relation of returns to

AFLs when market moments decline, we primarily focus our analysis on months when the

moments increase. Table 4, Panel A, provides results when VOL is positive, Panel B gives

results when SKEW is positive, and Panel C shows results when both VOL and SKEW are

positive. Panel D provides results when SKEW is positive and VOL is negative.

In the first three panels of Table 4, for both equal- and value-weighted returns, 5-1

portfolio returns are positive and significant for both VOL and SKEW AFL sorting.

However, in Panel A where market volatility is increasing, all ortho FF-3 alphas are small and

insignificant. Thus, when volatility is increasing, VOL and SKEW AFL effects on returns are

captured by the traditional three factors. In Panel B where market skewness is increasing, the

ortho FF-3 alphas are positive and significant for VOL AFLs when SKEW AFLs are

controlled for. The alphas are around one percent a month which is economically important.

When VOL AFLs are controlled for and the effect of SKEW AFLs are examined, the equal-

weighted ortho FF-3 alpha is significant, but the value-weighted one is not; alphas are about one-

half percent per month. Thus, when market skewness is increasing VOL AFLs have a unique

and important effect on returns. For SKEW AFLs the effect is somewhat weaker, but a

significant, unique effect remains for equal-weighted portfolios. In Panel C, the only significant

ortho FF-3 alpha is for sorting on SKEW AFLs with equal-weighted returns. Thus, only in

this instance do moment AFLs affect returns after controlling for standard risk factors.

14
 Panel D shows the impact that declining VOL has when SKEW is positive. As seen in

prior tables, falling VOL is associated with very high monthly returns. This association may

mask the impact of SKEW in portfolio analyses, and thus firm-level analysis is employed in the

next section to parse out the effects of VOL and SKEW AFLs in the cross-section of returns.

5.3 Fama and MacBeth (1973) Regressions

Finally, we estimate Fama and MacBeth (1973) cross-sectional regressions with firm-

level data. As with the earlier portfolio analyses, the first monthly cross-sectional regression is

for July, 2000. Independent variables include the AFLs on VOL and SKEW, log of size,

B/M, momentum, MKT beta, and liquidity beta. Separate estimations are performed for months

when VOL and SKEW are positive and for months when they are negative, and for months

when both VOL and SKEW are positive.

Table 5, Panel A, has results when VOL rises and Panel B gives results for when VOL

falls. When VOL increases, the coefficients on VOL AFL and SKEW AFL are positive and

significant at the 1% and 10% levels, respectively. These results are stronger than for portfolio

5-1 returns in Table 4, Panel A, where all ortho FF-3 alphas are insignificant. In these cross-

sectional regression results in Table 5, Panel A, involving all securities, the importance of VOL

and SKEW AFLs survive controls for the other moments AFL and standard variables known

to influence returns. When VOL falls, the coefficients on VOL AFL and SKEW AFL are

insignificant. The value of the VOL AFL coefficient is six times higher and the SKEW AFL

coefficient is over three times higher when VOL rises than when it falls. These results suggest a

lesser role for moment AFLs when VOL is negative.

15
 Table 5, Panel C, provides results when SKEW is positive and Panel D has results for

when SKEW is negative. When SKEW increases, the coefficients on VOL AFL and SKEW

AFL are positive and significant at the 1% and 5% levels, respectively. These findings are

consistent with and slightly stronger than those for 5-1 portfolios in Table 4, Panel B. Results in

Table 5, Panel C, are similar to those in Table 5, Panel A. In both cases the coefficients on

VOL AFL and SKEW AFL are significant even when the other moments AFL and other

variables are included. When SKEW falls, the coefficients on VOL AFL and SKEW AFL are

small and insignificant. These results suggest a lesser role for moment loadings when SKEW is

negative.

Panel E of Table 5 presents results when both VOL and SKEW are positive. The

coefficients on VOL AFL and SKEW AFL are highly positive and significant, and larger than

in any other panel. These results are also much stronger than the 5-1 portfolio results in Table 4,

Panel C, where only one ortho FF-3 alpha is marginally significant. Overall, results in Table 5

show that when VOL and/or SKEW are rising, stocks with greater sensitivity to either market

moment change perform better, even after controlling for other factors known to affect security

returns. These relations are stronger when analyzed at the security level (Table 5) than for

portfolios (Table 4), and are robust to firm size, book-to-market equity ratio, momentum, and

liquidity.

It is useful to examine the economic significance of the coefficients from the Fama and

MacBeth regressions. The mean VOL AFL is -2.97 with a standard deviation of 6.13, while

the mean SKEW AFL is -0.19 with a standard deviation of 2.44. So if both VOL and SKEW

are increasing, a one standard deviation increase in the VOL AFL has an impact of an increase

of (0.11 x 6.13) 0.674% on the monthly return, versus a one standard deviation increase in the

16
SKEW AFL having an impact of (0.49 x 2.44) 1.20% on returns. Thus, a stock's sensitivity to

changes in market skewness has a larger average contemporaneous impact (almost twice as

much) on stock's returns than its sensitivity to changes in market volatility.

6. Conclusion

We document the contemporaneous asymmetric relation of the cross-section of stock

returns and changes in the implied (or expected) volatility and skewness of the market. Using

the procedure established by BKM, the proxies for expected changes in market volatility and

skewness come from the second and third moments, respectively, of the risk-neutral distribution

of returns computed from options on the S&P 500. The relation between a stock's returns and its

sensitivity to changes in the market's risk-neutral volatility and skewness is asymmetric, and

differs cross-sectionally only when market volatility and skewness are increasing. When market

volatility and skewness are decreasing, the impact is relatively uniform across all stocks,

regardless of the stocks' estimated sensitivities. These findings are robust to other firm

characteristics commonly used to explain returns, such as firm size, book-to-market equity ratio,

momentum, and liquidity.

The empirical evidence demonstrates that, given implied market skewness or volatility is

increasing, the economic impact of sensitivity to changes in systematic skewness on returns is

between fifty and one hundred percent greater than that of the sensitivity to the changes in

systematic volatility. This indicates that a stock's sensitivity to changes in market skewness is

relatively important to investors. Portfolio managers should find these results both interesting

and useful, given the recent emphasis on market volatility measures, such as the VIX index, and

lack of importance placed on skewness. The asymmetric nature of the pricing of changes in

17
implied market volatility and skewness may provide investors a valuable way to speculate or

hedge their portfolios, and deserves further study.

18
 Appendix

Following BKM, let the continuously compounded return of the underlying stock index over
period t be R(t,)ln[S(t+)/S(t)]. Then the price of the quadratic contract at time t can be expressed as
V(t,)E*t[e-rR(t,)2]. Similarly, at time t, the price of the cubic and quartic contracts are W(t,)
E*t[e-rR(t,)3] and X(t,) E*t[e-rR(t,)4], respectively. The price of these contracts can be calculated
as:

(A1)

(A2)

(A3)

There are several sources that may introduce bias into the estimates of the risk-neutral moments.
Dennis and Mayhew (2002) address two sources of bias: the discreteness of the available data and the
asymmetry of the data with respect to puts and calls. Since market calls and puts are heavily traded
across many strike prices, asymmetry of put versus call data is not a problem in our study. However, the
available market options strike prices are not continuous, and thus bias is introduced into the estimates,
the size of which depends on the interval distance between strike prices. Dennis and Mayhew point out
that this bias is fairly consistent, though, and can be neglected without much harm when evaluating
cross-sectional differences.
These integrals in equations (A1), (A2), and (A3) may be approximated using a portfolio of
market option prices indexed by strike price. Following Dennis and Mayhew, the price of the market
options are recorded as the midpoint of the last bid-ask quote for each market option each day. We

19
approximate the daily prices of the V(t,), W(t,), and X(t,) contracts by discretizing the corresponding
integrals. The discretized long position in the calls of the volatility contract, V(t,), given in equation
(A1) is

where , and the discretized short position in the puts is

.

where . The cubic contract, W(t,), and the quartic contract, X(t,), given in

equations (A2) and (A3), respectively, are similarly discretized and estimated.
By Theorem 1 of BKM, the variance (VAR) and skewness (SKEW) of the risk-neutral
density are:
(A4)


(A5)

where
(t,) = er 1 erV(t,)/2 erW(t,)/6 erX(t,)/24. (A6)

20
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23
 Table 1. Summary Statistics and Correlations, January 1996-December 2007
Panel A reports the summary statistics of the Fama and French (1993) factors MKT, SMB, and HML, and the levels (and first
differences) in second and third risk-neutral moments, VOL (VOL) and SKEW (SKEW). Panel B reports the correlations between
the Fama and French (1993) factors MKT, SMB, and HML, and levels (and first differences) of VOL (VOL) and SKEW (SKEW).
Panel A: Summary Statistics
Observations Mean Standard Deviation Median Minimum Maximum
MKT 144 0.0049 0.044 0.0109 -0.162 0.082
SMB 144 0.0043 0.041 -0.0002 -0.075 0.220
HML 144 0.0040 0.037 0.0035 -0.124 0.139
VOL 144 16.236 5.143 15.385 7.224 36.27
SKEW 144 -5.052 5.120 -3.027 -30.55 -0.769
VOL 143 0.0633 3.572 0.0324 -7.60 13.19
SKEW 143 -0.0075 5.908 0.0019 -27.45 26.81

Panel B: Monthly Correlations

MKT SMB HML VOL SKEW VOL SKEW
MKT 1.000
SMB 0.224 1.000
HML -0.530 -0.486 1.000
VOL -0.367 -0.143 0.037 1.000
SKEW -0.153 0.015 0.052 0.302 1.000
VOL -0.549 -0.116 0.288 0.375 -0.011 1.000
SKEW -0.187 -0.072 0.112 0.060 0.575 0.067 1.000

24
 Table 2. Portfolios Sorted by Sensitivity to Innovations in Changes in Risk-Neutral Market Volatility
For each firm a regression is estimated of the form:

where ri,t is the excess return for firm i in month t, MKT t is the excess return of the CRSP value-weighted index from the
end month t-1 to the end of month t that is orthogonal to VOL and SKEW, VOL+ t is the innovation in VOL from the
end of month t-1 to the end of month t when VOL is positive and zero otherwise, VOL- t is the innovation in VOL from
the end of month t-1 to the end of month t when VOL is negative and zero otherwise, SKEW+ t is the innovation in
SKEW from the end of month t-1 to the end of month t when SKEW is positive and zero otherwise, SKEW- t is the
innovation in SKEW from the end of month t-1 to the end of month t when SKEW is negative and zero otherwise, and i,t
is an error term. This regression is estimated for each firm for June of year over 54 months ending in December of year
-1. We require at least 36 months of data and, thus, the earliest regressions end in December, 1999. The beta estimates
for each June of year are assigned to July of year through June of year +1. Although each firms parameter estimates
are held constant for twelve-month periods, they are used to create VOL adjusted factor loadings (VOL AFLs) each
month using the realized value of VOL for each respective month from July of year through June of year +1. The
VOL AFLs are computed as:
if VOL is greater than zero in month t or
if VOL is less than zero in month t
Firms are sorted each month into quintiles based on their VOL AFLs. Panel A presents equal- and value-weighted
average monthly returns in the post-formation period, the mean AFLs for the pre-formation periods, average natural log
of mean size (total market capitalization) and the average book-to-market equity ratio (B/M) of the firms in each quintile
portfolio. Equal- and value-weighted returns are calculated for each portfolio every month from July 2000 to December
2007. The row 5-1 refers to the mean difference in returns between quintile portfolios 5 and 1. Panels B and C report
the equal and value-weighted portfolio returns and the mean difference in returns between quintile portfolios 5 and 1, but
limit the sample to months where either the VOL is positive or negative, respectively. The alpha from regressing the 5-1
portfolio returns on the Fama and French (1993) three-factor model, with a market factor orthogonalized to VOL and
SKEW, is reported in the row labeled Ortho FF-3 Alpha. t-statistics are reported in parentheses.
Panel A: Portfolios sorted by the AFLs on VOL for the entire sample period.

Post-formation Monthly Returns (%)

Mean of Pre-formation Log of
VOL AFL Quintiles Equal weighted Value weighted VOL AFL size B/M
1 (Low) 0.92 -0.32 -10.99 5.44 0.70
2 1.21 0.56 -4.46 5.96 0.73
3 1.33 0.34 -2.02 5.98 0.77
4 1.36 0.44 -0.03 5.83 0.79
5 (High) 1.41 0.87 3.99 5.28 0.79
5-1 0.49 1.19**
(1.50) (2.49)
Ortho FF-3 Alpha 0.64** 1.00**
(2.06) (2.28)

**Significant at the 5% level.

25
 Panel B: Portfolios sorted by the AFLs on VOL when VOL is positive. Panel C: Portfolios sorted by the AFLs on VOL when VOL is negative.

Post-formation Monthly Returns (%) Post-formation Monthly Returns (%)

VOL AFL Quintiles Equal weighted Value weighted VOL AFL Quintiles Equal weighted Value weighted
1 (Low) -1.92 -3.12 1 (Low) 4.02 2.75
2 -0.97 -1.17 2 3.60 2.44
3 -0.48 -1.23 3 3.33 2.06
4 -0.66 -1.41 4 3.57 2.46
5 (High) -1.32 -1.45 5 (High) 4.39 3.41
5-1 0.60 1.67** 5-1 0.37 0.66
(1.23) (2.21) (0.85) (1.17)
Ortho FF-3 Alpha 0.12 0.31 Ortho FF-3 Alpha 0.52 0.61
(0.32) (0.50) (1.11) (0.97)
**Significant at the 5% level.

26
 Table 3. Portfolios Sorted by Sensitivity to Changes in Risk-Neutral Market Skewness
For each firm a regression is estimated of the form:

where ri,t is the excess return for firm i in month t, MKT t is the excess return of the CRSP value-weighted index from
the end month t-1 to the end of month t that is orthogonal to VOL and SKEW, VOL+ t is the innovation in VOL
from the end of month t-1 to the end of month t when VOL is positive and zero otherwise, VOL- t is the innovation
in VOL from the end of month t-1 to the end of month t when VOL is negative and zero otherwise, SKEW+ t is the
innovation in SKEW from the end of month t-1 to the end of month t when SKEW is positive and zero otherwise,
SKEW- t is the innovation in SKEW from the end of month t-1 to the end of month t when SKEW is negative and
zero otherwise, and i,t is an error term. This regression is estimated for each firm for June of year over 54 months
ending in December of year -1. We require at least 36 months of data and, thus, the earliest regressions end in
December, 1999. The beta estimates for each June of year are assigned to July of year through June of year +1.
Although each firms parameter estimates are held constant for twelve-month periods, they are used to create SKEW
adjusted factor loadings (SKEW AFLs) each month using the realized value of SKEW for each respective month
from July of year through June of year +1. The SKEW AFLs are computed as:
if SKEW is greater than zero in month t or
if SKEW is less than zero in month t
Firms are sorted each month into quintiles based on their SKEW AFLs. Panel A presents equal- and value-weighted
average monthly returns in the post-formation period, the mean AFLs for the pre-formation periods, average natural
log of mean size (total market capitalization) and the average book-to-market equity ratio (B/M) of the firms in each
quintile portfolio. Equal- and value-weighted returns are calculated for each portfolio every month from July 2000 to
December 2007. The row 5-1 refers to the mean difference in returns between quintile portfolios 5 and 1. Panels B
and C report the equal and value-weighted portfolio returns and the mean difference in returns between quintile
portfolios 5 and 1, but limit the sample to months where either the SKEW is positive or negative, respectively. The
alpha from regressing the 5-1 portfolio returns on the Fama and French (1993) three-factor model, with a market factor
orthogonalized to VOL and SKEW, is reported in the row labeled Ortho FF-3 Alpha. t-statistics are reported in
parentheses.
Panel A: Portfolios sorted by the AFLs on SKEW for the entire sample period.

Post-formation Monthly Returns (%) Mean of Pre-

formation
SKEW AFL Quintiles Equal weighted Value weighted SKEW AFL Log of size B/M
1 (Low) 0.90 0.04 -3.20 5.34 0.76
2 1.15 0.18 -1.06 5.92 0.76
3 1.29 0.40 -0.28 6.08 0.73
4 1.47 0.51 0.49 5.92 0.77
5 (High) 1.43 0.77 2.78 5.24 0.75
5-1 0.52** 0.74*
(2.39) (1.76)
Ortho FF-3 Alpha 0.31 0.29
(1.48) (0.79)
*Significant at the 10% level, **Significant at the 5% level

27
 Panel B: Portfolios sorted by the AFLs on SKEW when SKEW is positive. Panel C: Portfolios sorted by the AFLs on SKEW when SKEW is negative.

Post-formation Monthly Returns (%) Post-formation Monthly Returns (%)

SKEW AFL Quintiles Equal weighted Value weighted SKEW AFL Quintiles Equal weighted Value weighted
1 (Low) -0.67 -1.73 1 (Low) 2.55 1.88
2 0.09 -1.02 2 2.25 1.43
3 0.41 -0.44 3 2.21 1.28
4 0.59 -0.51 4 2.39 1.58
5 (High) 0.41 -0.33 5 (High) 2.49 1.92
5-1 1.08*** 1.40** 5-1 -0.06 0.04
(3.08) (2.20) (-0.26) (0.08)
Ortho FF-3 Alpha 0.57* 0.40 Ortho FF-3 Alpha -0.04 -0.02
(1.83) (0.83) (-0.18) (-0.05)
*Significant at the 10% level, **Significant at the 5% level, ***Significant at the 1% level.

28
 Table 4. Portfolio Returns Sorted by VOL and SKEW Adjusted Factor Loadings
The sample is independently sorted each month into quintiles based on the VOL and SKEW AFLs of each firm. The AFL'sare estimated from the regression:

where ri,t is the excess return for firm i in month t, MKT t is the excess return of the CRSP value-weighted index from the end month t-1 to the end of month t that is orthogonal to
VOL and SKEW, VOL+ t is the innovation in VOL from the end of month t-1 to the end of month t when VOL is positive and zero otherwise, VOL- t is the innovation in
VOL from the end of month t-1 to the end of month t when VOL is negative and zero otherwise, SKEW+ t is the innovation in SKEW from the end of month t-1 to the end of
month t when SKEW is positive and zero otherwise, SKEW- t is the innovation in SKEW from the end of month t-1 to the end of month t when SKEW is negative and zero
otherwise, and i,t is an error term. This regression is estimated for each firm for June of year over 54 months ending in December of year -1. We require at least 36 months of
data and, thus, the earliest regressions end in December, 1999. The beta estimates for each June of year are assigned to July of year through June of year +1. Although each
firms parameter estimates are held constant for twelve-month periods, they are used to create VOL and SKEW adjusted factor loadings (VOL and SKEW AFLs,
respectively) each month using the realized value of VOL or SKEW for each respective month from July of year through June of year +1. The SKEW AFLs are computed
as:
if SKEW is greater than zero in month t or
if SKEW is less than zero in month t
The VOL AFLs are similarly computed. Equal- and value-weighted returns are calculated for each portfolio every month from July 2000 to December 2007. Panel A (B) presents
the equal- and value-weighted returns for each quintile of VOL AFL averaged across quintiles of SKEW AFL and for each quintile of SKEW AFL averaged across quintiles of
VOL AFL for months when VOL (SKEW) is positive. Panel C presents similar results for months when both VOL and SKEW are positive. Panel D presents results for
months when VOL is negative and SKEW is positive. These panels also show the mean returns and ortho FF-3 alphas of the 5-1 portfolios. t-statistics are in parentheses.

Panel A: Mean Portfolio Returns Controlled Mean Portfolio Returns Controlled

When VOL is positive For SKEW AFL For VOL AFL
VOL AFL Rank Equal Weighted Value Weighted SKEW AFL Rank Equal Weighted Value Weighted
1 (Low) -1.90 -3.07 1 (Low) -1.96 -2.89
2 -1.04 -1.47 2 -1.20 -1.99
3 -0.60 -1.30 3 -0.70 -1.22
4 -0.78 -1.52 4 -0.52 -1.51
5 (High) -1.11 -1.41 5 (High) -1.05 -1.15
5-1 0.79* 1.67** 5-1 0.91** 1.74***
t (1.68) (2.40) t (2.57) (2.79)
Ortho FF-3 Alpha -0.25 -0.13 Ortho FF-3 Alpha 0.25 0.31
t (-0.66) (-0.13) t (0.56) (0.56)
*Significant at the 10% level, **Significant at the 5% level, ***Significant at the 1% level.

29
 Panel B: Mean Portfolio Returns Controlled Mean Portfolio Returns Controlled
When SKEW is positive For SKEW AFL For VOL AFL
VOL AFL Rank Equal Weighted Value Weighted SKEW AFL Rank Equal Weighted Value Weighted
1 (Low) -0.67 -1.89 1 (Low) -0.57 -1.60
2 0.15 -0.59 2 0.05 -0.84
3 0.43 -0.49 3 0.36 -0.45
4 0.54 -0.63 4 0.57 -0.69
5 (High) 0.45 0.07 5 (High) 0.50 0.05
*** *** ***
5-1 1.11 1.96 5-1 1.07 1.65**
t (3.03) (3.24) t (2.98) (2.58)
** * *
Ortho FF-3 Alpha 0.81 1.09 Ortho FF-3 Alpha 0.58 0.50
t (2.48) (1.99) t (1.79) (0.99)

Panel C: Mean Portfolio Returns Controlled Mean Portfolio Returns Controlled

When VOL and SKEW are positive For SKEW AFL For VOL AFL
VOL AFL Rank Equal Weighted Value Weighted SKEW AFL Rank Equal Weighted Value Weighted
1 (Low) -3.53 -4.58 1 (Low) -3.51 -4.63
2 -1.97 -2.41 2 -2.33 -3.44
3 -1.45 -2.31 3 -1.66 -2.13
4 -1.44 -2.57 4 -1.25 -2.32
5 (High) -1.94 -2.04 5 (High) -1.58 -1.39
5-1 1.58*** 2.54** 5-1 1.93*** 3.24***
t (2.94) (2.55) t (3.54) (3.23)
*
Ortho FF-3 Alpha 0.67 0.28 Ortho FF-3 Alpha 0.97 0.66
t (1.52) (0.33) t (1.84) (0.84)
*Significant at the 10% level, **Significant at the 5% level, ***Significant at the 1% level.

30
Panel D: Mean Portfolio Returns Controlled Mean Portfolio Returns Controlled
When SKEW is positive and VOL is negative For SKEW AFL For VOL AFL
VOL AFL Rank Equal Weighted Value Weighted SKEW AFL Rank Equal Weighted Value Weighted
1 (Low) 2.74 1.31 1 (Low) 2.93 2.00
2 2.67 1.57 2 2.88 2.26
3 2.68 1.69 3 2.77 1.55
4 2.91 1.67 4 2.73 1.25
5 (High) 3.30 2.58 5 (High) 2.98 1.76
**
5-1 0.56 1.27 5-1 0.05 -0.24
t (1.18) (2.17) t (0.15) (-0.49)
Ortho FF-3 Alpha 0.56 0.86 Ortho FF-3 Alpha 0.45 0.32
t (1.04) (1.22) t (1.18) (0.53)
**Significant at the 5 percent level.

31
 Table 5. Fama and MacBeth Regressions with VOL and SKEW AFLs, Size, B/M, Momentum, Orthogonalized Market Betas, and
Liquidity Betas
This table reports the Fama and MacBeth (1973) estimated premiums associated with the VOL and SKEW AFLs, natural log of size, B/M, 6-month momentum,
beta on MKT (where MKT is the MKT factor orthogonalized to VOL and SKEW), and the beta on liquidity (the coefficient on the Pastor and Stambaugh
(2003) liquidity variable in their four-factor model). Firm size is determined at the end of June in calendar year and assigned from July in calendar year to June in
year +1. B/M is the book value at fiscal year-end in calendar year -1 divided by the market capitalization of the firm at the end of December in year -1 and it is
assigned from July in calendar year to June in calendar year +1. Six-month momentum is the cumulative returns from the end of month t-6 to the end of month t-2.
The beta on MKT is estimated by using the regression:

where ri,t is the return of stock i in month t, MKTt is market factor in month t that is orthogonalized to VOL and SKEW, and i,t is an error term. This regression
is estimated for each firm for June of year on a monthly basis over 54 months (a minimum of 36 months of data are required) ending in December of year -1. The
beta estimates for each June of year are assigned to July of year through June of year +1. The liquidity betas are estimated using the regression:

where MKT, SMB, and HML are the Fama-French (1993) factors and LIQ is the Pastor and Stambaugh liquidity factor. The portfolio returns sample is from July
2000 to December 2007. Panel A (B) reports the results when VOL increases (decreases). Panel C (D) reports the results when SKEW increases (decreases). Panel E
reports the results when VOL and SKEW increase. Robust Newey-West (1987) t-statistics are in parentheses.
Panel A: Months Panel B: Months When Panel C: Months When Panel D: Months When Panel E: Months When
When VOL is VOL is Negative SKEW is Positive SKEW is Negative VOL and SKEW are
Positive Positive
VOL AFL 0.07*** 0.01 0.07*** 0.02 0.11***
(2.91) (0.64) (3.18) (0.76) (3.61)
SKEW AFL 0.23* 0.07 0.30** 0.00 0.49**
(1.85) (1.05) (2.31) (0.02) (2.25)
Log of Size -0.07 -0.17 -0.18 -0.05 -0.08
(-0.62) (-1.62) (-1.53) (-0.60) (-0.40)
B/M 0.22 0.41** 0.37** 0.25 0.23
(1.17) (2.17) (2.11) (1.30) (0.98)
Momentum (6-month) 1.14** -0.15 1.41*** -0.42 1.93***
(2.22) (-0.20) (3.10) (-0.47) (2.79)
MKT Beta -0.94** 0.83** -0.50* 0.33 -1.27***
(-2.55) (2.55) (-1.90) (0.83) (-3.49)
*
Liquidity Beta -0.002 -0.002 0.000 0.001 0.003
(1.89) (-0.75) (0.19) (0.42) (1.40)
*Significant at the 10 percent level, **Significant at the 5 percent level, ***Significant at the 1 percent level.

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