Beta is sensitive to the level of risk aversion

We have just written about the impact of changing beta. See There is no one beta - It changes across regimes. This is not new information, but researchers have taken a deeper look at the issue and have found some interesting relationships. Another paper that has found an interesting beta relationship is “Risk Appetite and (Mis)Pricing”. It has examined some beta portfolios conditional on high and low risk aversion. The risk aversion index was developed in prior research and is not new, but it has not been used in this type of study.

The results are strong and very thought-provoking. In a high-risk aversion environment, the researchers find a positive relationship between beta and returns. In contrast, in a low-risk aversion environment, there is a slight negative relationship between beta and returns. This can help explain why we do not find the usual CAPM relationship in the data. When risk aversion is high, the market risk premium idominatesother factors that may create distortions, such as sentiment. When risk aversion is low, mispricing becomes more important, and there is a positive relationship with a positive intercept. The study carefully examines the evidence and finds that risk aversion plays a key role in determining whether the CAPM holds or fails. When aversion to risk is low, sentiment-driven mispricing will be the key driver of returns and will offset the market risk premium effect.