Persistence of jump-induced tail risk and limits to arbitrage

K. Victor Chow, Kose John, Jingrui Li and Ben Sopranzetti

Quantitative Finance, 2023, vol. 23, issue 4, 705-719

Abstract: We present a novel methodology to calculate the jump-induced tail risk premium for individual stocks and examine its effect on the following-month’s returns. The existence of a premium for bearing negative jump-induced tail risk is significantly associated with negative one-month future returns. In contrast, the existence of a positive premium for bearing jump-induced tail risk has no such significant predictive power. Further, we find that the larger is the magnitude of the premium for negative jump-induced tail risk, the greater and longer-lasting is its impact on expected returns. Lastly, the observed ten-day lag taken to fully incorporate negative jump tail information into price is consistent with limits to arbitrage in the underlying stocks.

Date: 2023
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DOI: 10.1080/14697688.2022.2151502

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