Revisiting the ICAPM under the distortion of risk-return tradeoff in short-horizon stock returns

We suggest that the distortion of the positive risk-return relation in the ICAPM is a consequence of trading by informed investors to exploit mispricing. We hypothesize and demonstrate that a non-positive (strongly positive) risk-return relation following positive (negative) market returns is attributed to short-selling (purchasing) of overpriced (underpriced) stocks along with optimistic (pessimistic) expectations conditional on good (bad) market news. We verify this asymmetry in the risk-return relation through the indirect risk-return relation conditional on good (bad) market news. We also find that the attenuation (reinforcement) of the positive risk-return relation is more profound in high- (low-) sentiment periods.