Tail Risk and Asset Prices

Abstract:     
I propose a new measure of time-varying tail risk that is directly estimable from the cross section of returns. I exploit firm-level price crashes every month to identify common fluctuations in tail risk across stocks. My tail measure is highly correlated with tail risk measures extracted from S&P 500 index options, but is available for a longer sample since it is calculated from equity data. I show that tail risk has strong predictive power for aggregate market returns: A one standard deviation increase in tail risk forecasts an increase in excess market returns of 5% over the following year. Cross-sectionally, stocks with high loadings on past tail risk earn average annual returns 6% higher than stocks with low tail risk loadings. These findings are consistent with asset pricing theories that relate equity risk premia to disasters or other heavy-tailed risks.

Number of Pages in PDF File: 49

Keywords: Tail risk, time-varying expected returns, cross section of returns

JEL Classification: G11, G12, G13, G17

working papers series