Risk Premia: Asymmetric Tail Risks and Excess Returns

TL;DR

This paper demonstrates that risk premia are closely linked to tail-risk skewness, introduces a new skewness measure, and distinguishes genuine risk premia from market anomalies like trend following.

Contribution

It provides empirical evidence connecting risk premia to skewness, proposes a new skewness definition, and offers a criterion to evaluate risk-premium strategies.

Findings

Risk premia correlate strongly with tail-risk skewness.

Trend following exhibits positive skewness and excess returns, unlike typical risk premia.

Some strategies are market anomalies, not genuine risk premia.

Abstract

We present extensive evidence that ``risk premium'' is strongly correlated with tail-risk skewness but very little with volatility. We introduce a new, intuitive definition of skewness and elicit an approximately linear relation between the Sharpe ratio of various risk premium strategies (Equity, Fama-French, FX Carry, Short Vol, Bonds, Credit) and their negative skewness. We find a clear exception to this rule: trend following has both positive skewness and positive excess returns. This is also true, albeit less markedly, of the Fama-French ``Value'' factor and of the ``Low Volatility'' strategy. This suggests that some strategies are not risk premia but genuine market anomalies. Based on our results, we propose an objective criterion to assess the quality of a risk-premium portfolio.