We introduce a family of utility functions that describe the preferences of mean-variance-downside-risk (mvdr) averse investors. The risk premium on a risky asset in an economy with these individuals is given by a weighted sum of CAPM systematic risk and a systematic risk given by the level of comovements between the asset and the market in distress episodes. Hence investors require a higher reward than predicted by CAPM for holding assets correlated with the market in distress episodes, and a lower reward for holding assets with negative correlation in market downturns. The application of this pricing theory to financial sectors in FTSE-100 is illuminating. The empirical failure of standard CAPM is explained by the extra reward required by investors from market downturns. While Chemicals and Mining sectors exhibit positive comovements with FTSE downturns; Banking and Oil and Gas sectors are robust to them and Telecommunications Services exhibit negative comovements serving as refugee of investors fleeing from domestic market distress episodes.
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Post, G.T. & Vliet, P. van, 2004.
"Conditional Downside Risk and the CAPM,"
Research Paper
ERS-2004-048-F&A Revision, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus Uni.
[Downloadable!]
Post, G.T. & Vliet, P. van, 2004.
"Downside Risk and Asset Pricing,"
Research Paper
ERS-2004-018-F&A Revision, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus Uni.
[Downloadable!]
Other versions:
Andrew Ang & Joseph Chen & Yuhang Xing, 2005.
"Downside Risk,"
NBER Working Papers
11824, National Bureau of Economic Research, Inc.
[Downloadable!] (restricted)