International Business Review 12 (2003) 523541

www.elsevier.com/locate/ibusrev

The relationships between unsystematic risk,

skewness and stock returns during up and
down markets
Gordon Y.N. Tang
a

a,b,m

, Wai Cheong Shum

Department of Finance and Decision Sciences, Hong Kong Baptist University, Kowloon Tong,
Kowloon,
Hong Kong
b
International Graduate School of Management, University of South Australia, Adelaide,
Australia
Received 7 April 2003; revised 14 May 2003; accepted 15 May 2003

Abstract
A recent article published in International Business Review (12 (2003) 109) argues for
the usefulness of beta as a measure of risk in international stock markets. The beta-return
re- lationship is signicantly positive (negative) when the market excess returns are
positive (negative). This paper extends their study further by examining other statistical
risk mea- sures. It is well known that stock returns are non-normally distributed with
signicant skew- ness and kurtosis. Under the same conditional framework, investors
are found not only compensated for bearing beta risk, but also for bearing unsystematic
risk, providing evi- dence that international investors do not hold well-diversied
portfolios. Skewness, but not kurtosis, plays a signicant role in pricing international
stock returns. Investors accept less positive returns for positively skewed portfolios. Total
risk is signicantly and positively (negatively) related to realized weekly returns during
up (down) markets. Our results sup- port previous ndings and add that other statistical
risk measures are also useful in explain- ing the cross-sectional variations in international
stock returns, and hence, are relevant to portfolio managers.
# 2003 Elsevier Ltd. All rights reserved.
Keywords: Riskreturn; Conditional CAPM; Beta; Skewness; International markets

Corresponding author. Tel.: +852-3411-7563; fax: +852-3411-5585.

E-mail address: gyntang@hkbu.edu.hk (G.Y.N. Tang).

0969-5931/$ - see front matter # 2003 Elsevier Ltd. All rights

reserved. doi:10.1016/S0969-5931(03)00074-X

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1.

G.Y.N. Tang, W.C. Shum / International Business Review 12 (2003) 523541

Introduction

The riskreturn relationship has long been an important and relevant question
asked by both academic scholars and real-world business practitioners. The
famous capital-asset pricing model (CAPM) developed by Sharpe (1964) and
Lintner (1965) not only proposes that a linear relationship exists between the
expected re- turn on a risky asset and its systematic risk, but also that the
systematic risk, beta, is the only relevant risk measure. Fama and MacBeth (1973)
empirically support the validity of CAPM using the US stock returns.
However, the adequacy of CAPM has been seriously challenged over the past 20
years (e.g. Fama & French, 1992, 1996b; Jegadeesh, 1992). The empirical evidence
indicates that betas are not signicantly related to returns. Other factors such
as size, earnings/price ratio, cash-ow/price ratio, book-to-market ratio, and
past sales growth add even more signicant explanation to the average returns
(e.g., Ball, 1978; Banz, 1981; Basu, 1977; Berk, 1995; Chan, Hamao & Lakonishok,
1991; Fama & French, 1992, 1996a; Lakonishok & Shapiro, 1984; Lakonishok,
Shleifer & Vishny, 1994), so beta no longer fullls its role in measuring risk.
However, Pettengill et al. (1995) proposed an alternative approach to assess the
reliability of beta in measuring risk. Investors realize that there is a nonzero
prob- ability that the market return will be less than the risk-free return. If the
realized market return is greater than the risk-free rate for sure, no investor is
willing to hold the risk-free asset. In addition, as beta is a risk measurement, an
asset with a higher beta should have a higher risk than an asset with a lower
beta. Hence, it is argued that when the realized market returns exceed the riskfree rate (i.e. the rea- lized market excess returns are positive or up markets),
there should be a positive relationship between betas and realized returns.
Similarly, when the realized mar- ket excess returns are negative (down markets),
there should be a negative relation- ship between betas and realized returns.
Using the US stock market data in period 19361990, they found a signicantly
positive (negative) relationship between beta and realized returns where market
excess returns are positive (negative). They also found support for a positive riskreturn tradeo.
Following the approach of Pettengill, Sundaram and Mathur (1995), empirical
studies have been performed on other stock markets. Fletcher (1997) examined
the conditional relationship between beta and returns in the UK between 1975
and 1994 and found a signicant conditional relationship. However, this
relationship in up and down markets is not symmetrical as the relationship is
stronger in down markets. Isakov (1999) examined the conditional relationship
in the Swiss stock market for the period 19831991. He found supportive results
that beta is signi- cantly related to realized returns and has the expected sign.
Hodoshima, Garza- Go mez and Kunimura (2000) investigated the relationship
between returns and beta in the Japanese stock market for the period 19521995.
Signicant conditional relationship between returns and beta is found and that
relationship is in general better t in down markets than in up markets in terms
of the goodness of t mea- sures (R2 and the standard error of the equation).

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