The Pricing of Volatility and Skewness: A New Interpretation

Abstract

Investors who perceive themselves to possess superior security selection skill will be want to invest more heavily in securities with highly volatile and skewed returns, because it is among those securities that the largest winners can generally be found. If fundamental investors overestimate, or oversell, their skill, the result will be the relative overpricing of highly volatile and skewed securities. This article develops a simple model that draws out the implications of the foregoing observation. The implications of that model are consistent with recent empirical work which points to the overpricing of highly volatile and skewed securities.

TOPICS: Volatility measures, security analysis and valuation, risk management