Jumps in Rank and Expected Returns. Introducing Varying Cross-sectional Risk

Santosh Mishra, Gloria Gonzalez-Rivera and Tae Hwy Lee

No 356, Econometric Society 2004 North American Winter Meetings from Econometric Society

Abstract: Decision theorists claim that an ordinal measure of risk may be sufficient for an agent to make a rational choice under uncertainty. We propose a measure of financial risk, namely the Varying Cross-sectional Risk (VCR), that is based on a ranking of returns. VCR is defined as the probability of a sharp jump over time in the position of an asset return within the cross-sectional return distribution of the assets that constitute the market, which is represented by the Standard and Poor's 500 Index (SP500). We model the joint dynamics of the cross-sectional position and the asset return by analyzing (1) the marginal probability distribution of a sharp jump in the cross-sectional position within the context of a duration model, and (2) the probability distribution of the asset return conditional on a jump, for which we specify different return dynamics depending upon whether or not a jump has taken place. As a result, the marginal probability distribution of returns is a mixture of distributions. The performance of our model is assessed in an out-of-sample exercise. We design a set of trading rules that are evaluated according to their profitability and riskiness. A trading rule based on our VCR model is dominant providing superior mean trading returns and accurate estimation of the Value-at-Risk.

Keywords: Duration; Mixture of distributions; Nonlinearity; Reality check; Trading rule; VaR (search for similar items in EconPapers)
JEL-codes: C3 C5 G0 (search for similar items in EconPapers)
Date: 2004-08-11
New Economics Papers: this item is included in nep-fin
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