Extreme Downside Risk and Expected Stock Returns

Journal of Banking and Finance, Vol. 36, No. 5, 2012, 1492-1502

34 Pages Posted: 22 Mar 2009 Last revised: 17 May 2012

See all articles by Wei Huang

Wei Huang

University of Hawaii at Manoa - Shidler College of Business

Qianqiu Liu

University of Hawaii at Manoa - Shidler College of Business

S. Ghon Rhee

University of Hawaii - Shidler College of Business; University of Hawaii - Department of Financial Economics and Institutions

Feng Wu

University of Macau - Faculty of Business Administration

Date Written: March 18, 2009

Abstract

We propose a measure for extreme downside risk (EDR) to investigate whether bearing such a risk is rewarded by higher expected stock returns. Constructing an EDR proxy with the left tail index in the classical generalized extreme value distribution, we document a significantly positive premium on firm-specific EDR in cross-section of stock returns even after controlling for market, size, value, momentum, and liquidity effects. The EDR premium is more prominent among glamour stocks and when high market returns are expected. High-EDR stocks generally have high idiosyncratic risk, large downside beta, lower coskewness and cokurtosis, and high bankruptcy risk. The EDR premium persists after these characteristics are controlled for. EDR is also closely related to firm-specific Value at Risk (VaR) which substantially impacts EDR’s effect on expected stock returns. EDR supplements VaR in predicting stock returns by exhibiting additional explanatory power.

Keywords: Extreme Downside Risk, Generalized Extreme Value Distribution, Idiosyncratic Volatility, Bankruptcy Risk

JEL Classification: G10; G12; and G33

Suggested Citation

Huang, Wei and Liu, Qianqiu and Rhee, S. Ghon and Wu, Feng, Extreme Downside Risk and Expected Stock Returns (March 18, 2009). Journal of Banking and Finance, Vol. 36, No. 5, 2012, 1492-1502. Available at SSRN: https://ssrn.com/abstract=1364622 or http://dx.doi.org/10.2139/ssrn.1364622

Wei Huang

University of Hawaii at Manoa - Shidler College of Business ( email )

2404 Maile Way
Honolulu, HI 96822
United States
808-956-7679 (Phone)
808-956-9887 (Fax)

Qianqiu Liu (Contact Author)

University of Hawaii at Manoa - Shidler College of Business ( email )

2404 Maile Way, E602f
Honolulu, HI 96822
United States
808-956-8736 (Phone)
808-956-9887 (Fax)

S. Ghon Rhee

University of Hawaii - Shidler College of Business ( email )

2404 Maile Way
C-304, FEI/CBA
Honolulu, HI 96822
United States

University of Hawaii - Department of Financial Economics and Institutions ( email )

United States

Feng Wu

University of Macau - Faculty of Business Administration ( email )

Av. Padre Tomas Pereira
Macau
Macau

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