Betting Against Correlation: Testing Theories of the Low-risk Effect

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

*Corresponding author for this work

Research output: Contribution to journalJournal articleResearchpeer-review

Abstract

We test whether the low-risk effect is driven by leverage constraints and, thus, risk should be measured using beta versus behavioral effects and, thus, risk should be measured by idiosyncratic risk. Beta depends on volatility and correlation, with only volatility related to idiosyncratic risk. We introduce a new betting against correlation (BAC) factor that is particularly suited to differentiate between leverage constraints and behavioral 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.
Original languageEnglish
JournalJournal of Financial Economics
Volume135
Issue number3
Pages (from-to)629-652
Number of pages24
ISSN0304-405X
DOIs
Publication statusPublished - Mar 2020

Bibliographical note

Available online, July 12 2019

Keywords

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

Cite this

Asness, Clifford S. ; Frazzini, Andrea ; Gormsen, Niels Joachim ; Pedersen, Lasse Heje. / Betting Against Correlation : Testing Theories of the Low-risk Effect. In: Journal of Financial Economics. 2020 ; Vol. 135, No. 3. pp. 629-652.
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Betting Against Correlation : Testing Theories of the Low-risk Effect. / Asness, Clifford S.; Frazzini, Andrea; Gormsen, Niels Joachim; Pedersen, Lasse Heje.

In: Journal of Financial Economics, Vol. 135, No. 3, 03.2020, p. 629-652.

Research output: Contribution to journalJournal articleResearchpeer-review

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T2 - Testing Theories of the Low-risk Effect

AU - Asness, Clifford S.

AU - Frazzini, Andrea

AU - Gormsen, Niels Joachim

AU - Pedersen, Lasse Heje

N1 - Available online, July 12 2019

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AB - We test whether the low-risk effect is driven by leverage constraints and, thus, risk should be measured using beta versus behavioral effects and, thus, risk should be measured by idiosyncratic risk. Beta depends on volatility and correlation, with only volatility related to idiosyncratic risk. We introduce a new betting against correlation (BAC) factor that is particularly suited to differentiate between leverage constraints and behavioral 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.

KW - Asset pricing

KW - Leverage constraints

KW - Lottery demand

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KW - Sentiment

KW - Asset pricing

KW - Leverage constraints

KW - Lottery demand

KW - Margin

KW - Sentiment

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