Extreme Risk, excess return and leverage: the LP formula

Olivier Le Marois (), Julia Mikhalevski () and Raphael Douady ()
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Olivier Le Marois: Fluks
Julia Mikhalevski: FEDERIS Gestion d'actif

Documents de travail du Centre d'Economie de la Sorbonne from Université Panthéon-Sorbonne (Paris 1), Centre d'Economie de la Sorbonne

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)
JEL-codes: G11 (search for similar items in EconPapers)
Pages: 20 pages
Date: 2014-12
New Economics Papers: this item is included in nep-rmg
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ftp://mse.univ-paris1.fr/pub/mse/CES2014/14094.pdf (application/pdf)

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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Persistent link: https://EconPapers.repec.org/RePEc:mse:cesdoc:14094

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