Extreme downside risk and market turbulence

Richard D.F. Harris, Linh H. Nguyen*, Evarist Stoja

*Corresponding author for this work

Research output: Contribution to journalArticle (Academic Journal)peer-review

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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.

Original languageEnglish
Pages (from-to)1875-1892
Number of pages18
JournalQuantitative Finance
Issue number11
Early online date10 Jun 2019
Publication statusPublished - 2 Nov 2019

Structured keywords

  • AF Financial Markets


  • Downside risk
  • Tail risk
  • Markov switching
  • Value-at-Risk
  • Leverage effect
  • Volatility feedback effect


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