Extreme Downside Risk and Market Turbulence.

Quantitative Finance, Forthcoming

Posted: 30 Apr 2019

See all articles by Richard D. F. Harris

Richard D. F. Harris

University of Bristol, School of Accounting and Finance; affiliation not provided to SSRN

Linh Nguyen

University of Exeter

Evarist Stoja

University of Bristol

Date Written: April 29, 2019

Abstract

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

Harris, Richard D. F. and Nguyen, Linh and Stoja, Evarist, Extreme Downside Risk and Market Turbulence. (April 29, 2019). Quantitative Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3379745

Richard D. F. Harris

University of Bristol, School of Accounting and Finance ( email )

United Kingdom

HOME PAGE: http://www.bristol.ac.uk/people/person/Richard-Harris-50ffa5fb-0e86-4458-8e8c-8dace6eb3435/

affiliation not provided to SSRN

Linh Nguyen

University of Exeter ( email )

Northcote House
The Queen's Drive
Exeter, Devon EX4 4QJ
United Kingdom

Evarist Stoja (Contact Author)

University of Bristol ( email )

School of Accounting and Finance
8 Woodland Road
Bristol, BS8 1TN
United Kingdom

HOME PAGE: http://sites.google.com/view/evarist-stoja/

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