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Getting Paid to Hedge: Why Don’t Investors Pay a Premium to Hedge Downturns?

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  • Kapadia, Nishad
  • Ostdiek, Barbara Bennett
  • Weston, James P.
  • Zekhnini, Morad

Abstract

Stocks that hedge sustained market downturns should have low expected returns, but they do not. We use ex ante firm characteristics and covariances to construct a tradable safe minus risky (SMR) portfolio that hedges market downturns out of sample. Although downturns (peaks to troughs in market index levels at the business-cycle frequency) predict significant declines in gross domestic product growth, SMR has significant positive average returns and 4-factor alphas (both around 0.8% per month). Risk-based models do not explain SMR’s returns, but mispricing does. Risky stocks are overpriced when sentiment is high, resulting in subsequent returns of -0.9% per month.

Suggested Citation

  • Kapadia, Nishad & Ostdiek, Barbara Bennett & Weston, James P. & Zekhnini, Morad, 2019. "Getting Paid to Hedge: Why Don’t Investors Pay a Premium to Hedge Downturns?," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 54(3), pages 1157-1192, June.
    • Handle: RePEc:cup:jfinqa:v:54:y:2019:i:03:p:1157-1192_00
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    Cited by:

    1. Tong Wang, 2023. "Bear Beta or Speculative Beta?—Reconciling the Evidence on Downside Risk Premium," Review of Finance, European Finance Association, vol. 27(1), pages 325-367.

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