Extreme downside risk and market turbulence

Date

2019-06-10

Advisors

Journal Title

Journal ISSN

ISSN

Volume Title

Publisher

Taylor and Francis

Type

Article

Peer reviewed

Yes

Abstract

We investigate the dynamics of the relationship between returns and extreme downside risk in different states of the market by combining the framework of Bali, Demirtas, and Levy (2009) with a Markov switching mechanism. We show that the risk-return relationship identified by Bali, Demirtas, and Levy (2009) is highly significant in the low volatility state but disappears during periods of market turbulence. This is puzzling since it is during such periods that downside risk should be most prominent. We show that the absence of the risk-return relationship in the high volatility state is due to leverage and volatility feedback effects arising from increased persistence in volatility. To better filter out these effects, we propose a simple modification that yields a positive tail risk-return relationship in all states of market volatility.

Description

The file attached to this record is the author's final peer reviewed version. The Publisher's final version can be found by following the DOI link.

Keywords

Downside risk, Tail risk, Markov switching, Value-at-Risk, Leverage effect, Volatility feedback effect

Citation

Harris, R.D., Nguyen, L.H. and Stoja, E., (2019) (Accepted/In press). Extreme downside risk and market turbulence. Quantitative Finance,

Rights

Research Institute

Finance and Banking Research Group (FiBRe)