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Are extreme returns priced in the stock market? European evidence

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  • Annaert, Jan
  • De Ceuster, Marc
  • Verstegen, Kurt

Abstract

This paper revisits some recently found evidence in the literature on the cross-section of stock returns for a carefully constructed dataset of euro area stocks. First, we confirm recent results for US data and find evidence of a negative cross-sectional relation between extreme positive returns and average returns after controlling for characteristics such as momentum, book-to-market, size, liquidity and short term return reversal. We argue that this is the case because these stocks have lottery-like characteristics, which is attractive to certain investors. Also, these stocks tend to be very volatile so that arbitrageurs are discouraged from correcting potential mispricing. As a consequence, these stocks are often overpriced and hence face lower expected returns. Second, when we control for extreme returns, the recently found negative relationship between idiosyncratic risk and future returns is less robust. In our models, after adding maximum returns, the relationship is insignificant and sometimes even positive. We also find that idiosyncratic skewness and coskewness play an important role for asset pricing, as predicted by several theoretical models.

Suggested Citation

  • Annaert, Jan & De Ceuster, Marc & Verstegen, Kurt, 2013. "Are extreme returns priced in the stock market? European evidence," Journal of Banking & Finance, Elsevier, vol. 37(9), pages 3401-3411.
  • Handle: RePEc:eee:jbfina:v:37:y:2013:i:9:p:3401-3411
    DOI: 10.1016/j.jbankfin.2013.05.015
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    References listed on IDEAS

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    1. repec:eco:journ1:2018-02-19 is not listed on IDEAS
    2. repec:eee:finlet:v:23:y:2017:i:c:p:147-151 is not listed on IDEAS
    3. Nartea, Gilbert V. & Kong, Dongmin & Wu, Ji, 2017. "Do extreme returns matter in emerging markets? Evidence from the Chinese stock market," Journal of Banking & Finance, Elsevier, vol. 76(C), pages 189-197.
    4. Zhong, Angel & Gray, Philip, 2016. "The MAX effect: An exploration of risk and mispricing explanations," Journal of Banking & Finance, Elsevier, vol. 65(C), pages 76-90.
    5. Chan, Yue-Cheong & Chui, Andy C.W., 2016. "Gambling in the Hong Kong stock market," International Review of Economics & Finance, Elsevier, vol. 44(C), pages 204-218.
    6. repec:eee:reveco:v:53:y:2018:i:c:p:1-15 is not listed on IDEAS
    7. Aboulamer, Anas & Kryzanowski, Lawrence, 2016. "Are idiosyncratic volatility and MAX priced in the Canadian market?," Journal of Empirical Finance, Elsevier, vol. 37(C), pages 20-36.

    More about this item

    Keywords

    Extreme returns; Cross-section of expected returns; Lottery-like payoffs; Skewness; Idiosyncratic volatility puzzle;

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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