High Risk Episodes and the Equity Size Premium

We find that the equity size premium is pervasively positive, sizable, and statistically significant solely over periods that follow a high-risk month; defined as a month that ends with the expected market volatility being in its top quintile. Following the other lower-risk months, the size premium is essentially zero and statistically insignificant. Conditional CAPM alphas for Small-minus-Big (SMB) long/short portfolio returns also exhibit a very similar risk-based contingent variation. Concurrently, SMB returns are negative and reliably lower in the months leading up to our topquintile-volatility condition. Our results indicate a nonlinear positive intertemporal risk-return relation for the equity size premium, seemingly attributed to high-risk episodes where small-cap stocks face relatively higher market volatility-, illiquidity-, and default-risk. Our findings suggest support for: (1) Acharya-Pedersen’s (2005) implication that persistent illiquidity shocks can generate low concurrent returns and higher future returns, (2) Hahn-Lee’s (2006) and Kapadia’s (2011) view that default risk has a role for understanding the size premium, and (3) Ang et al’s (2006) view that stocks with a more negative sensitivity to market volatility innovations should have a higher risk premium.

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