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Persistence of jump-induced tail risk and limits to arbitrage

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  • K. Victor Chow
  • Kose John
  • Jingrui Li
  • Ben Sopranzetti

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.

Suggested Citation

  • K. Victor Chow & Kose John & Jingrui Li & Ben Sopranzetti, 2023. "Persistence of jump-induced tail risk and limits to arbitrage," Quantitative Finance, Taylor & Francis Journals, vol. 23(4), pages 705-719, April.
    • Handle: RePEc:taf:quantf:v:23:y:2023:i:4:p:705-719
    DOI: 10.1080/14697688.2022.2151502
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