Persistence of Jump-Induced Tail Risk and Limits to Arbitrage

Quantitative Finance, Forthcoming

49 Pages Posted: 22 Nov 2022 Last revised: 27 Nov 2022

See all articles by Victor Chow

Victor Chow

West Virginia University - Department of Finance

Kose John

New York University (NYU) - Leonard N. Stern School of Business

Jingrui Li

Stevens Institute of Technology - School of Business

Ben J. Sopranzetti

Rutgers Business School: Newark and New Brunswick

Date Written: October 25, 2022

Abstract

We present a novel methodology to calculate the jump-induced tail risk premium for individual stocks and examine its effect on the following-month’s returns. The existence of a premium for bearing negative jump-induced tail risk is significantly associated with negative one-month future returns. In contrast, the existence of a positive premium for bearing jump-induced tail risk has no such significant predictive power. Further, we find that the larger is the magnitude of the premium for negative jump-induced tail risk, the greater and longer-lasting is its impact on expected returns. Lastly, the observed ten-day lag taken to fully incorporate negative jump tail information into price is consistent with limits to arbitrage in the underlying stocks.

Keywords: tail risk, asymmetry, cross-section of stock returns, return prediction, empirical asset pricing

JEL Classification: G11, G12, G17

Suggested Citation

Chow, Victor and John, Kose and Li, Jingrui and Sopranzetti, Ben J., Persistence of Jump-Induced Tail Risk and Limits to Arbitrage (October 25, 2022). Quantitative Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=4276824 or http://dx.doi.org/10.2139/ssrn.4276824

Victor Chow

West Virginia University - Department of Finance ( email )

P. O. Box 6025
Morgantown, WV 26506
United States

Kose John

New York University (NYU) - Leonard N. Stern School of Business ( email )

Jingrui Li (Contact Author)

Stevens Institute of Technology - School of Business ( email )

Hoboken, NJ 07030
United States

Ben J. Sopranzetti

Rutgers Business School: Newark and New Brunswick ( email )

100 Rockafeller Rd
Piscataway, NJ 08854
United States

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