On the cross-sectional asymmetric dependence between investment returns

Abstract

The benefits of diversification decrease substantially during market downturns due to asymmetric dependence between stock and market returns. Not all assets are affected in the same way. This thesis provides a substantial evidence of the cross-sectional variation in asymmetric dependence between equity returns and market returns across the 38 largest financial markets and a variety of asset classes. I document that asymmetric dependence between stock returns and market returns is significantly priced in international equity returns. Of all the commonly considered factors, asymmetric dependence is the only factor that is priced in all 38 markets examined. Internationally, investors require additional compensation to hold assets displaying asymmetric dependence. Notably, the degree of asymmetric dependence increases faster in countries experiencing stronger growth in their financial markets. This thesis supports recognition of asymmetric dependence as a risk factor that has significant implications for, inter alia, asset pricing, cost of capital, and performance evaluation. Moreover, I build a general equilibrium model to identify important drivers of the cross-sectional variation in asymmetric dependence. I show that stocks with a high level of fundamental cash-flow risk exhibit a large amount of time variation in conditional betas and a relatively higher degree of the cross- sectional asymmetric dependence. The asymmetric effects of heterogeneous cash-flow risk on the cross section of return dependence are driven by preference shocks correlated with the business cycle. The model predictions are confirmed by US industry data.