Implications of Asymmetry Risk for Portfolio Analysis and Asset Pricing

Bank of Canada working papers are theoretical or empirical works-in-progress on subjects in economics and finance. The views expressed in this paper are those of the authors. No responsibility for them should be attributed to the Bank of Canada. ii Acknowledgements We thank Scott Hendry, Kenneth Judd and Wally Speckert for very helpful conversations. We thank seminar participants at the EC 2 Conference in Rotterdam for helpful comments. Abstract Asymmetric shocks are common in markets; securities' payoffs are not normally distributed and exhibit skewness. This paper studies the portfolio holdings of heterogeneous agents with preferences over mean, variance and skewness, and derives equilibrium prices. A three funds separation theorem holds, adding a skewness portfolio to the market portfolio; the pricing kernel depends linearly only on the market return and its squared value. Our analysis extends Harvey and Siddique's (2000) conditional mean-variance-skewness asset pricing model to non-vanishing risk-neutral market variance. The empirical relevance of this extension is documented in the context of the asymmetric GARCH-in-mean model of Bekaert and Liu (2004). Classification JEL : C52, D58, G11, G12 Classification de la Banque : Marchés financiers; Structure de marché et fixation des prix