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Extreme downside risk and financial crises

Richard Harris, Linh H Nguyen () and Evarist Stoja ()
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Linh H Nguyen: University of Exeter
Evarist Stoja: University of Bristol

No 547, Bank of England working papers from Bank of England

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, Demirtas, and Levy (2009) with a Markov switching mechanism. We show that the risk-return relationship identified by Bali, Demirtas, and Levy (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 under all states of market volatility.

Keywords: Downside risk; Markov switching; financial crisis; value at risk; leverage effect; volatility feedback effect. (search for similar items in EconPapers)
JEL-codes: C13 C14 C58 G10 G11 G12 (search for similar items in EconPapers)
Pages: 39 pages
Date: 2015-09-11
New Economics Papers: this item is included in nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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