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.
Original language | English |
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Pages (from-to) | 1875-1892 |
Number of pages | 18 |
Journal | Quantitative Finance |
Volume | 19 |
Issue number | 11 |
Early online date | 10 Jun 2019 |
DOIs | |
Publication status | Published - 2 Nov 2019 |
Structured keywords
- AF Financial Markets
Keywords
- Downside risk
- Tail risk
- Markov switching
- Value-at-Risk
- Leverage effect
- Volatility feedback effect