Campbell R. Harvey
Duke University, Durham, NC 27708, USA
National Bureau of Economic Research, Cambridge, MA 02138, USA
Georgetown University, Washington, DC 20057, USA
If asset returns have systematic conditional skewness, expected returns should incorporate rewards for accepting this risk. We formalize this intuition with an asset pricing model which incorporates conditional skewness. We decompose the expected excess returns into components due to conditional variance and skewness. Our results show that conditional skewness is important and, when combined with the economy-wide reward for skewness, helps explain the time-variation of the ex ante market risk premium. Conditional skewness has greater success in explaining the ex ante risk premium for the world portfolio than for the U.S. portfolio. We also use our model to explain the cross-sectional variation of expected returns and find that incorporating conditional skewness risk helps.