Extreme downside risk and market turbulence

Harris, Richard D F; Nguyen, Linh H; Stoja, Evarist

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, Demirtas, and Levy (2009) with a Markov switching mechanism. We show that the risk-return relationship identified by Bali, Demirtas, and Levy (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.

Citation

Harris, R. D. F., Nguyen, L. H., & Stoja, E. (2019). Extreme downside risk and market turbulence. Quantitative Finance, 19(11), 1875-1892. https://doi.org/10.1080/14697688.2019.1614652

• Journal Article Type: Article
• Acceptance Date: Apr 29, 2019
• Online Publication Date: Jun 10, 2019
• Publication Date: Jun 10, 2019
• Deposit Date: Aug 21, 2023
• Publicly Available Date: Aug 25, 2023
• Journal: Quantitative Finance
• Print ISSN: 1469-7688
• Electronic ISSN: 1469-7696
• Publisher: Routledge
• Peer Reviewed: Peer Reviewed
• Volume: 19
• Issue: 11
• Pages: 1875-1892
• DOI: https://doi.org/10.1080/14697688.2019.1614652
• Keywords: Downside risk; Tail risk; Markov switching; Value-at-Risk; Leverage effect; Volatility feedback effect JEL classification: C13, C14, C53, G10, G12
• Public URL: https://nottingham-repository.worktribe.com/output/24574546
• Publisher URL: https://www.tandfonline.com/doi/abs/10.1080/14697688.2019.1614652?journalCode=rquf20
• Additional Information: This is an Accepted Manuscript of an article published by Taylor & Francis in Quantitative Finance on 10/06/2019, available at: https://doi.org/10.1080/14697688.2019.1614652