Asymmetric risk premium in value and growth stocks

There are two competing explanations for the existence of a value premium, a rational market risk explanation, whereby value stocks are inherently more risky than growth stocks, and a market over-reaction hypothesis, where agents overstate future returns on growth stock. Using asymmetric GARCH-M models this paper tests the predictions of the two hypotheses. Specifically, examining whether returns exhibit a positive (negative) risk premium resulting from a negative (positive) shock and the relative size of any premium. The results of the paper suggest that following a shock, volatility and expected future volatility are heightened, leading to a rise in required rates of return which depresses current prices. Further, these effects are heightened for value stock over growth stock and for negative shocks over positive shocks. Thus, in support of the rational risk interpretation, with a volatility feedback explanation for predictive volatility asymmetry.