Betting Against Correlation

Testing Theories of the Low-risk Effect

Clifford S. Asness, Andrea Frazzini, Niels Joachim Gormsen, Lasse Heje Pedersen

Research output: Working paperResearch

Abstract

We test whether the low-risk effect is driven by (a) leverage constraints and thus risk should be measured using beta vs. (b) behavioral effects and thus risk should be measured by idiosyncratic risk. Beta depends on volatility and correlation, where only volatility is related to idiosyncratic risk. Hence, the new factor betting against correlation (BAC) is particularly suited to differentiating between leverage constraints vs. lottery explanations. BAC produces strong performance in the US and internationally, supporting leverage constraint theories. Similarly, we construct the new factor SMAX to isolate lottery demand, which also produces positive returns. Consistent with both leverage and lottery theories contributing to the low-risk effect, we find that BAC is related to margin debt while idiosyncratic risk factors are related to sentiment and casino profits.
Original languageEnglish
Place of PublicationLondon
PublisherCentre for Economic Policy Research
Number of pages65
Publication statusPublished - 2018
SeriesCentre for Economic Policy Research. Discussion Papers
NumberDP12686
ISSN0265-8003

Keywords

  • Asset pricing
  • Leverage constraints
  • Lottery demand
  • Margins
  • Sentiment

Cite this

Asness, C. S., Frazzini, A., Gormsen, N. J., & Pedersen, L. H. (2018). Betting Against Correlation: Testing Theories of the Low-risk Effect. London: Centre for Economic Policy Research. Centre for Economic Policy Research. Discussion Papers, No. DP12686
Asness, Clifford S. ; Frazzini, Andrea ; Gormsen, Niels Joachim ; Pedersen, Lasse Heje. / Betting Against Correlation : Testing Theories of the Low-risk Effect. London : Centre for Economic Policy Research, 2018. (Centre for Economic Policy Research. Discussion Papers; No. DP12686).
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Asness, CS, Frazzini, A, Gormsen, NJ & Pedersen, LH 2018 'Betting Against Correlation: Testing Theories of the Low-risk Effect' Centre for Economic Policy Research, London.

Betting Against Correlation : Testing Theories of the Low-risk Effect. / Asness, Clifford S.; Frazzini, Andrea; Gormsen, Niels Joachim; Pedersen, Lasse Heje.

London : Centre for Economic Policy Research, 2018.

Research output: Working paperResearch

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Asness CS, Frazzini A, Gormsen NJ, Pedersen LH. Betting Against Correlation: Testing Theories of the Low-risk Effect. London: Centre for Economic Policy Research. 2018.