Extreme Risk, excess return and leverage: the LP formula

Olivier Le Marois (), Julia Mikhalevsky () and Raphael Douady ()
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Olivier Le Marois: fluks - FLUKS
Julia Mikhalevsky: FEDERIS Gestion d'Actifs - Federis Gestion d'Actifs

Université Paris1 Panthéon-Sorbonne (Post-Print and Working Papers) from HAL

Abstract: The LP formula is based upon the substitution of the exogenous risk aversion hypothesis by a credit equilibrium hypothesis. This leads to a trade-off between expected blue-sky return – the expected return excluding default scenarios – and extreme risk estimated from scenarios leading to default. An empirical study on the past 90 years shows that this trade-off curve is almost identical across asset classes. In equilibrium, an asset expected blue-sky return is proportional to its contribution to extreme risk. Assuming normal returns, we obtain CAPM as a sub-case of the LP relation. This relationship makes extreme risk underestimation a strong driver of asset price bubbles.

Keywords: asset allocation; extreme risk; CAPM; risk budgeting; equilibrium (search for similar items in EconPapers)
Date: 2014-12
New Economics Papers: this item is included in nep-fmk and nep-rmg
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Published in 2014

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Related works:
Working Paper: Extreme Risk, excess return and leverage: the LP formula (2014)
Working Paper: Extreme Risk, excess return and leverage: the LP formula (2014)
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