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VIRTUALLY ALL OF THE early studies of the Sharpe-Lintner capital asset pricing model (CAPM) found the predicted linear relationship between return and the non-diversifiable risk of risky assets, generally represented by common stocks listed on the New York Stock Exchange (NYSE). However, they also found that this return-risk relationship seemed to imply for most periods a riskless market rate of return substantially above any reasonable measure of the actual risk-free rates of return. Recent papers point to a similar result if the market portfolio of risky assets is represented by an appropriately weighted portfolio of common stocks and bonds instead of common stocks alone.1 Thus, it is noteworthy that a study by Kraus and Litzenberger finds that a measure6 of co-skewness can be used as a supplement to the co-variance measure of risk to explain the returns on individual NYSE stocks, and in the process to explain the otherwise observed discrepancies between these returns and the returns on NYSE stocks as a whole.2 In other words, they extend capital asset pricing theory to incorporate the effect of skewness in return distributions, making the assumption that investors have a preference for positive return skewness in their portfolios (and therefore positive or negative co-skewness in individual assets depending on the skewness in the market portfolio).3 As a consequence Kraus and Litzenberger are apparently able to explain observed returns in the stock market without the substitution of a non-observable zerobeta construct for the risk-free rate. Kraus and Litzenberger assume that just as investors are averse to variance in their portfolios, and therefore beta in individual assets, they prefer positive skewness in their portfolios. Hence, since they also assume that all investors hold the market portfolio, investors would be willing to pay a premium for assets which possess positive co-skewness with the market if |
