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Does expected idiosyncratic skewness of firms' profit predict the cross-section of stock returns? Evidence from China

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  • Zhang, Qun
  • Zhang, Peihui
  • Liu, Hao

Abstract

Motivated by existing evidence of a preference among investors for assets with lottery-like payoffs and for portfolios that are under-diversified, this study investigates the relation between expected idiosyncratic skewness of firms' profit (EISP) and cross-sectional stock returns, using samples from the Chinese A-share market. Portfolio-level analyses and firm-level cross-sectional regressions suggest that firms with higher EISP have lower expected returns than those with lower EISP. A long-short value-weighted portfolio can earn an annualized risk-adjusted excess return (i.e., Fama-French five-factor alpha) of 11.3% when sorting by the EISP. The negative effect of EISP on the cross-sectional stock returns is robust to controlling for well-documented firm characteristics and risk factors, rather than being subsumed by firms' profit instability or accounting-based downside risk. Of particular interest, the effect is more pronounced among stocks with more lottery-like characteristics, indicating that the immaturity of investors is an underlying driver of the mispricing in the effect.

Suggested Citation

  • Zhang, Qun & Zhang, Peihui & Liu, Hao, 2023. "Does expected idiosyncratic skewness of firms' profit predict the cross-section of stock returns? Evidence from China," Research in International Business and Finance, Elsevier, vol. 64(C).
    • Handle: RePEc:eee:riibaf:v:64:y:2023:i:c:s0275531922002252
    DOI: 10.1016/j.ribaf.2022.101839
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    Keywords

    Expected idiosyncratic skewness of firms' profit; Mispricing; Lottery preferences; Chinese stock market;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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