Which is Worse: Heavy Tails or Volatility Clusters?

60 Pages Posted: 17 Apr 2023 Last revised: 28 Apr 2023

See all articles by Joshua Traut

Joshua Traut

University of St. Gallen

Wolfgang Schadner

University of St. Gallen

Date Written: April 5, 2023

Abstract

Heavy tails and volatility clusters are both stylized facts of financial returns that destabilize markets. The former are extreme events by definition and the latter can accelerate adverse market developments. This work disentangles the two sources and examines which one does the greater damage to financial stability, whether the threat can be reduced via diversification, and how an acknowledgment of volatility clustering can enhance the quality of risk models. The analysis is carried out for index return series representing seven different asset classes and for individual stock portfolio return series. The isolation of the stylized facts is achieved under recent developments in surrogate analysis (IAAFT, IAAWT). While tail risk historically received more attention, especially in financial regulation, our analysis shows that volatility clusters have a greater impact on maximum drawdowns and aggregate losses across all return series. We further find that diversification does not yield any protection from those risks. These findings have important implications for financial regulators, risk managers, and investors seeking to understand and mitigate the risks of financial markets.

Keywords: Financial Stability, Tail Risk, Autocorrelation, Volatility Clustering, Heavy Tails, Risk Management

JEL Classification: G12, G18, G15, G01

Suggested Citation

Traut, Joshua and Schadner, Wolfgang, Which is Worse: Heavy Tails or Volatility Clusters? (April 5, 2023). Available at SSRN: https://ssrn.com/abstract=4410908 or http://dx.doi.org/10.2139/ssrn.4410908

Joshua Traut (Contact Author)

University of St. Gallen ( email )

Swiss Institute of Banking and Finance
Unterer Graben 21
St.Gallen, St. Gallen 9000
Switzerland

Wolfgang Schadner

University of St. Gallen

Switzerland

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