The Tail Behavior of Stock Returns: Emerging Versus Mature Markets

Abstract

For central banks, institutional, and individual investors, it is crucial to understand the frequency and importance of drops or sudden rises in financial markets. Extreme value theory (EVT) is an interesting tool providing answers to questions such as: With what frequency do we find variations of returns beyond a given threshold? Over a given period, what type of extreme variation can be expected? In a cross-country setting of emerging and mature financial markets do extreme variations behave in a similar manner?

In the following paper we start with a review of theoretical elements of EVT. In the empirical section of this study we consider five mature markets, nine Asian, six Eastern European, and seven Latin American emerging markets. The tail behavior of returns is found to be compatible with the existence of up to the third moment but not beyond. The estimation of the tail distribution as a Generalized Pareto Distribution shows that great care has to be taken for emerging markets where little data is available and returns' distribution is subject to violate the IID assumption. Using a subsample of countries we demonstrate the limitations of evt. We also show that little can be learned from 19th century US data about presently emerging markets' tail behavior.

Keywords: Extreme value theory, Generalized Pareto distribution, Stock-market

JEL Classification: C13, C22, G15, O16