Tail Risk and Asset Prices
Bryan T. Kelly
University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)
Erasmus University Rotterdam (EUR)
August 1, 2013
Chicago Booth Research Paper No. 13-67
We propose a new measure of time-varying tail risk that is directly estimable from the cross section of returns. We exploit firm-level price crashes every month to identify common fluctuations in tail risk across stocks. Our tail measure is significantly 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. We 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 4.5% over the following year. Cross-sectionally, stocks with high loadings on past tail risk earn an annual three-factor alpha 5.4% higher than stocks with low tail risk loadings. These findings are consistent with asset pricing theories that relate equity risk premia to rare disasters or other forms of tail risk.
Number of Pages in PDF File: 55
Keywords: tail risk, time-varying risk, conditional expected returns, cross section of returns
JEL Classification: G11, G12, G13, G17
Date posted: September 5, 2013 ; Last revised: January 11, 2014
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