Conditional Skewness of Aggregate Market Returns

The characteristics of the distribution of security returns, such as skewness, play a significant role in financial theory and practice. This paper examines whether conditional skewness of daily aggregate market returns is predictable and investigates the economic mechanisms underlying this predictability. In both developed and emerging markets, there is strong evidence that lagged returns predict skewness; returns are more negatively skewed following an increase in stock prices and returns are more positively skewed following a decrease in stock prices. The empirical evidence shows that the traditional explanations such as the leverage effect, the volatility feedback effect, the stock bubble model (Blanchard and Watson, 1982), and the fluctuating uncertainty theory (Veronesi, 1999) are not driving the predictability of conditional skewness at the market level. The relation between skewness and lagged returns is most consistent with the Cao, Coval, and Hirshleifer (2002) model. There is some weak evidence that in developed countries, high trend-adjusted turnover predicts more negative skewness in returns. We examine if short-sale constraints play a role in the relation between lagged trend-adjusted turnover and skewness as posit by Hong and Stein (2003). We find evidence contrary to the Hong and Stein (2003) model. Our findings have implications for future theoretical and empirical models of time-varying market returns. JEL classification code: