Extreme Downside Risk and Market Turbulence.
Quantitative Finance, Forthcoming
Posted: 30 Apr 2019
Date Written: April 29, 2019
We investigate the dynamics of the relationship between returns and extreme downside risk in different states of the market by combining the framework of Bali, Demirtas, and Levy (2009) with a Markov switching mechanism. We show that the risk-return relationship identified by Bali, Demirtas, and Levy (2009) is highly significant in the low volatility state but disappears during periods of market turbulence. This is puzzling since it is during such periods that downside risk should be most prominent. We show that the absence of the risk-return relationship in the high volatility state is due to leverage and volatility feedback effects arising from increased persistence in volatility. To better filter out these effects, we propose a simple modification that yields a positive tail risk-return relationship in all states of market volatility.
Keywords: Downside risk, Tail risk, Markov switching, Value-at-Risk, Leverage effect, Volatility feedback effect
JEL Classification: C13, C14, C53, G10, G12
Suggested Citation: Suggested Citation