Are extreme returns priced in the stock market? European evidence

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 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 return reversal. We argue that this is the case because these stocks have lottery-like characteristics. Second, when we control for this relation, the idiosyncratic volatility puzzle seems to disappear. When extreme positive returns are included in the regression, we find a weak but positive relation between idiosyncratic volatility and returns. Lastly, the maximum return effect holds when we control for skewness. Moreover, skewness is on its own negatively related to returns in our sample, as several asset pricing models predict.