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Extreme downside risk and market turbulence

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  • Richard D. F. Harris
  • Linh H. Nguyen
  • Evarist Stoja

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 et al. [Is there an intertemporal relation between downside risk and expected returns? Journal of Financial and Quantitative Analysis, 2009, 44, 883–909] with a Markov switching mechanism. We show that the risk-return relationship identified by Bali et al. (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.

Suggested Citation

  • Richard D. F. Harris & Linh H. Nguyen & Evarist Stoja, 2019. "Extreme downside risk and market turbulence," Quantitative Finance, Taylor & Francis Journals, vol. 19(11), pages 1875-1892, November.
    • Handle: RePEc:taf:quantf:v:19:y:2019:i:11:p:1875-1892
    DOI: 10.1080/14697688.2019.1614652
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    Cited by:

    1. Dai, Yingtong & Harris, Richard D.F., 2023. "Average tail risk and aggregate stock returns," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 82(C).
    2. Roh, Tai-Yong & Byun, Suk Joon & Xu, Yahua, 2020. "Downside uncertainty shocks in the oil and gold markets," International Review of Economics & Finance, Elsevier, vol. 66(C), pages 291-307.

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