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Getting Paid to Hedge: Why Don’t Investors Pay a Premium to Hedge Downturns?

Published online by Cambridge University Press:  07 September 2018

Nishad Kapadia ,
Barbara Bennett Ostdiek ,
James P. Weston  and
Morad Zekhnini
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Abstract

Stocks that hedge sustained market downturns should have low expected returns, but they do not. We use ex ante firm characteristics and covariances to construct a tradable safe minus risky (SMR) portfolio that hedges market downturns out of sample. Although downturns (peaks to troughs in market index levels at the business-cycle frequency) predict significant declines in gross domestic product growth, SMR has significant positive average returns and 4-factor alphas (both around 0.8% per month). Risk-based models do not explain SMR’s returns, but mispricing does. Risky stocks are overpriced when sentiment is high, resulting in subsequent returns of -0.9% per month.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 54 , Issue 3 , June 2019 , pp. 1157 - 1192
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2018 

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Footnotes

1

We thank Hendrik Bessembinder (the editor), Oliver Boguth (the referee), and seminar participants at Rice University, Southern Methodist University, University of Melbourne, and University of North Carolina at Charlotte for helpful comments and suggestions.

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