The Drivers of Downside Equity Tail Risk

Abstract

We analyze the cross-sectional differences in the tail risk of equity returns and identify the drivers of tail risk. We provide two statistical procedures to test the hypothesis of cross-sectional downside tail shape homogeneity. An empirical study of 230 US non-financial firms shows that between 2008 and 2011 the cross-sectional tail shape is homogeneous across equity returns. The heterogeneity in tail risk over this period can be entirely attributed to differences in scale. The differences in scales are driven by the following firm characteristics: market beta, size, book-to-market ratio, leverage and bid-ask spread.

Keywords: Extreme Value Theory, Hypothesis Testing, Tail Index, Tail Risk

JEL Classification: C12, G11, G12