In equity markets financial investors are structurally long. The basis for both risk premia and implied subsidies is uncertainty about earnings prospects and about the discount factor for long-term dividend payments. This uncertainty manifests in high price volatility in share prices, compared to the standards in cash fixed income markets. Moreover, initial capital owners often pay a subsidy for receiving financing and risk sharing. Since 1900 equity investors have been paid a significant premium for bearing equity price risk: according to a long-term global study real equity returns have been 5% per annum, versus just 1.8% for government bonds and 1% on short-term deposits (view post here).
When risk aversion (as opposed to actual riskiness of assets) is high a part of equity investors are willing to sacrifice risk-adjusted returns in order to avoid exposure to the “pain” of experiencing large mark-to-market drawdowns and outsized volatility that violates formal risk metrics. This translates into an implicit subsidy to investors with stable risk aversion. Estimates of this subsidy can be based on the variance risk premium (or volatility risk premium), a premium paid to those bearing the risk of volatility of volatility, often measured by the difference between options-implied and expected realized variance (view post here) or the difference between variance swap rates and expected realized variance (view post here). Analogously, a premium is charged for the uncertainty of correlation of securities among each other or with a market benchmark. This is called correlation risk premium and arises from the common experience that correlations surge and diversification decreases in market crises, summarized in the adage that in a crash ‘all correlations go to one’ (view post here). Correlation risk premia can be estimated based on option prices and their implied correlation across stocks.
In normal times, however, investors often pay a premium for stocks with higher volatility and market beta (view post here). This is because many investors are constrained in their use of financial leverage: high-volatility stocks given them greater market exposure and higher expected absolute returns. As a consequence, risk-adjusted returns of high-volatility stocks have historically underperformed those of low-volatility stocks, a phenomenon that is called the “low-risk effect” and that can be exploited by leveraged investors in form of “betting against volatility” or “betting against beta” (view post here). There is a whole range of stylized low-risk strategies discussed in financial research that seems to have produced consistently alpha over time (view post here).
Equity also seems to pay a statistical arbitrage risk premium (view post here). Assets can be hedged against factor exposure through peer assets. The expected return on a hedged position is the arbitrage risk premium, which is estimable, for example, by ‘elastic net’ machine learning. ‘Unique’ stocks have higher excess returns than ‘ubiquitous’ stocks. It is a valid basis for trading strategies.
Finally, investors seem to overpay for stocks that have high “emotion betas”, i.e. the emotional “glitter” of stocks, measured as sensitivity to the emotional state of the market (forthcoming post). Empirical research suggests that emotion betas significantly and positively predict subsequent return differentials across stocks. This is backed by theories of emotional utility in investments that imply predictable behaviour of investors that covet emotions.