Study on the Relationship between Mixed Tail Risk and Expected Stock Returns

Abstract

The relationship between risk and asset returns is an important basis for investment decision.The mystery of "idiosyncratic volatility" shows that this relationship is still unclear.How to measure the correlation of risk and returns accurately has always been a popular investment spot. Traditional research of tail risk from one-dimensional and multi-dimensional perspective is relatively rich, using conditional heteroscedasticity model or extreme value theory to measure the basic risk indicators such as Value at Risk(VaR) and Expected Shortfall(ES),or estimating the common tail risk factor based on cross-sectional data of stocks.Existing research does not consider the same direction changes between asset and market returns,which is more pronounced during market crashes.In this paper, we examine the impact of mixed tail risk on the expected stock returns from multi-dimensional perspective based on coupla method.We find that: (1) The coefficient of lower tail dependence(LTD) can capture market crashes,we can use LTD as an warning indicator for market crashes. Stocks traded on Shenzhen Main Board with strong LTD have higher future returns than that with weaker LTD, but this conclusion does not apply to the stocks traded on Small and Mid Enterprise board(SME board) and Growth Enterprise market(GEM). (2) In the period of financial crisis, the positive impact of stock mixed tail risk on stock expected return will be significantly enhanced.High circulation market capitalization and high turnover rate can reduce this impact. (3) Non-tradable Share Reform increases the liquidity of stocks,reducing the risk premium of mixed tail risk.