Reconciling negative return skewness with positive time-varying risk premia

Abstract One of the implications of the intertemporal capital asset pricing model (ICAPM) is a positive and linear relationship between the conditional mean and conditional variance of returns to the market portfolio. Empirically, however, it is often observed that there is a negative skewness in equity returns. This article shows that a negative skewness is only compatible with a positive risk premium if the innovation distribution is asymmetric with a negative skewness. We extend recent work using the EGARCH-in-Mean specification to allow for asymmetric innovations, and give results for the unconditional skewness of returns. We apply the model to the prediction of Value-at-Risk of the largest stock market indices, and demonstrate its good performance. Keywords: Exponential GARCH, in-mean, risk premium, ICAPM, unconditional skewness, asymmetric distribution, portfolio selection, Value-at-Risk.