“Betting Against Correlation: Testing Theories of the Low-Risk Effect” won second place in the Journal of Financial Economics’ 2020 Fama-DFA Prizes for Capital Markets and Asset Pricing. The Fama-DFA Prizes annually recognize the best papers published in the JFE in the categories of capital markets and asset pricing. Read more from the JFE here.
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.
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