Betting Against Correlation: Testing Theories of the Low-Risk Effect

Lasse Pedersen, Clifford S. Asness, Andrea Frazzini and Niels Gormsen

No 12686, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: We test whether the low-risk effect is driven by (a) leverage constraints and thus risk should be measured using beta vs. (b) behavioral effects and thus risk should be measured by idiosyncratic risk. Beta depends on volatility and correlation, where only volatility is related to idiosyncratic risk. Hence, the new factor betting against correlation (BAC) is particularly suited to differentiating between leverage constraints vs. lottery explanations. BAC produces strong performance in the US and internationally, supporting leverage constraint theories. Similarly, we construct the new factor SMAX to isolate lottery demand, which also produces positive returns. Consistent with both leverage and lottery theories contributing to the low-risk effect, we find that BAC is related to margin debt while idiosyncratic risk factors are related to sentiment and casino profits.

Keywords: Asset pricing; Leverage constraints; Lottery demand; Margin; Sentiment (search for similar items in EconPapers)
JEL-codes: G02 G12 G14 G15 (search for similar items in EconPapers)
Date: 2018-02
New Economics Papers: this item is included in nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Journal Article: Betting against correlation: Testing theories of the low-risk effect (2020)
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