Extreme downside risk and market turbulence
Harris, RDF; Nguyen, L; Stoja, E
Date: 10 June 2019
Article
Journal
Quantitative Finance
Publisher
Taylor & Francis (Routledge)
Publisher DOI
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 ...
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 riskreturn 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.
Finance and Accounting
Faculty of Environment, Science and Economy
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