Can the Premium for Idiosyncratic Tail Risk be Explained by Exposures to its Common Factor?

90 Pages Posted: 8 Jan 2021 Last revised: 27 May 2021

See all articles by Fred Liu

Fred Liu

University of Western Ontario, Department of Economics

Date Written: November 1, 2020

Abstract

Stocks in the highest idiosyncratic tail risk decile earn 7.3% higher average annual returns than in the lowest. I propose a risk-based explanation for this premium, in which shocks to intermediary funding cause idiosyncratic tail risk to follow a strong factor structure, and the factor, common idiosyncratic tail risk (CITR), comoves with intermediary funding. Consequently, firms with high idiosyncratic tail risk have high exposure to CITR shocks, and command a risk premium due to their low returns when intermediary constraints tighten. To test my explanation, I create a novel measure of idiosyncratic tail risk that is estimated using high-frequency returns, and theoretically establish its time-aggregation properties. Consistent with my explanation, CITR shocks are procyclical, correlated to intermediary factors, priced in assets, and explain the idiosyncratic tail risk premium. Furthermore, volume tail risk also earns a premium, follows a strong factor structure, and its common factor is priced. This duality of idiosyncratic tail risk and volume tail risk provides evidence for my risk-based explanation, and further supports the hypothesis that intermediaries' large trades cause idiosyncratic tail risk and volume tail risk from Gabaix et al. (2006).

Keywords: Idiosyncratic tail risk, Volume tail risk, Common idiosyncratic tail risk factor, Power law, High-Frequency factor model, Tail risk premia, Intermediary asset pricing

JEL Classification: G12, C14, C58

Suggested Citation

Liu, Fred, Can the Premium for Idiosyncratic Tail Risk be Explained by Exposures to its Common Factor? (November 1, 2020). Available at SSRN: https://ssrn.com/abstract=3711215 or http://dx.doi.org/10.2139/ssrn.3711215

Fred Liu (Contact Author)

University of Western Ontario, Department of Economics ( email )

London, Ontario
Canada

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