Extreme Value Theory and Fat Tails in Equity Markets

Abstract

Extreme Value Theory (EVT) offers a powerful framework to characterize financial market crashes and booms. This paper applies EVT to model the behavior of extreme events and compares tail thickness between emerging and developed market equity return distributions. We extend previous results by augmenting parametric Monte Carlo tests with nonparametric bootstrap tests. We construct Monte Carlo and Bootstrapping experiments to estimate the statistical significance of differences in tail behavior between markets and regions. Within each market we find little evidence for asymmetry between positive and negative tails. We find mixed evidence for uniformity inside each region, and strong evidence for differences in tail behavior between emerging and developed regions. Our regional results have important implications for the expected diversification benefits of international portfolio allocation decisions.

Keywords: Power-laws, risk management, bootstrap

JEL Classification: G12, G15, C15