Tail Risk and Asset Prices
Bryan T. Kelly
University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)
November 19, 2012
Chicago Booth Research Paper No. 11-17
Fama-Miller Working Paper
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, G17working papers series
Date posted: May 2, 2011 ; Last revised: November 29, 2012
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