Think on the Downside: Multifactor asset pricing models based on downside risk and their performance relative to the CAPM, FF3F and Momentum
Abstract: This paper introduces two new measures of asset performance in a downside risk--reward framework. The first measure, Omega--H, is an extension of the Omega ratio from Keating and Shadwick (2002a) that captures an asset's idiosyncratic downside risk and upside potential. The second measure, the Vega, captures the asset's systematic downside risk and upside potential. The two measures are used to construct two factor portfolios which act as an extension of the CAPM, thus forming a three--factor model incorporating downside risk. As a control, an alternative three-- factor model is introduced that extends the CAPM to include factors formed on asset co--skewness and co--kurtosis with the market. The two models, called MOV (Market--Omega--Vega) and MCC (Market--Co--skewness--Co--kurtosis), are tested in a time series and in the cross--section together with the CAPM, the Fama--French three--factor model, and the Fama--French three--factor model extended by Momentum (Carhart, 1997). The Co--skewness and Co--kurtosis portfolios are priced by the other factor models, and the MCC model performs poorly in the cross--section. At the same time, the MOV model outperforms the FF3F model in the cross--section and prices the Momentum factor. Further tests show that the performance of all factor models in the cross--section is conditional on the market return for the period, consistent with conditionally varying risk premia. All factor models perform well in bull markets and poorly in bear markets. Unlike the other models, the MOV model outperforms the CAPM in extreme bear markets. A simple portfolio allocation test shows that including the Co--skewness, Co--kurtosis, Omega and Vega factors into an international index portfolio mitigates the home bias of US investors in portfolio allocation, consistent with Guidolin and Timmermann (2008).
AT THIS PAGE YOU CAN DOWNLOAD THE WHOLE ESSAY. (follow the link to the next page)