Abstract
We propose a measure for extreme downside risk (EDR) to investigate whether bearing such a risk is rewarded by higher expected stock returns. By constructing an EDR proxy with the left tail index in the classical generalized extreme value distribution, we document a significantly positive EDR premium in cross-section of stock returns even after controlling for market, size, value, momentum, and liquidity effects. The EDR premium is more prominent among glamor stocks and when high market returns are expected. High-EDR stocks are generally characterized by high idiosyncratic risk, large downside beta, lower coskewness and cokurtosis, and high bankruptcy risk. The EDR premium persists after these characteristics are controlled for. Although Value at Risk (VaR) plays a significant role in explaining the EDR premium, it cannot completely subsume the EDR effect.
Original language | English |
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Pages (from-to) | 1492-1502 |
Number of pages | 11 |
Journal | Journal of Banking and Finance |
Volume | 36 |
Issue number | 5 |
DOIs | |
Publication status | Published - May 2012 |
Externally published | Yes |
Bibliographical note
The authors would like to thank an anonymous referee, Ike Mathur (the Editor), Turan Bali, Hank Bessembinder, Wentworth Boynton, Charles Cao, Hui Chen, Yong Chen, Zhiwu Chen, Bing Liang, and conference discussants and participants at the 2008 China International Conference in Finance (CICF) (Dalian), the 2009 Western Finance Association (WFA) annual meeting (San Diego), the 2009 Financial Management Association International (FMA) annual (Reno) and Asian (Xiamen) conferences, the 2009 Asian Finance Association annual conference (Brisbane), the 2010 Five-Star Finance Forum (Beijing), and seminar participants at Hong Kong Polytechnic University, University of Melbourne, University of New South Wales, University of Sydney, University of Hawaii at Manoa, University of Macau, Renmin University of China for very valuable comments.Funding
Feng Wu acknowledges financial support from University of Macau Start-up Research Grant.
Keywords
- Bankruptcy risk
- Extreme downside risk
- Generalized extreme value distribution
- Idiosyncratic risk