Tail Risk and the Macroeconomy

Abstract:

We investigate how tail risk relates to macroeconomic fundamentals and uncertainty. We introduce a novel univariate time series model to study the dynamics of tail risk in financial returns: we apply results from extreme value theory and build a time-varying peaks over threshold model; and we specify the laws of motion for the parameters through the score-based approach. We further propose a connectedness measure for the comovement in tail risk among portfolios. We apply the model to daily returns from U.S. size-sorted decile stock portfolios and show that tail risk is countercyclical: tail risk goes up when fundamentals deteriorate and macroeconomic uncertainty increases; and larger firms tend to respond more than smaller ones. We further show that the degree of tail connectedness among portfolios is highly countercyclical. Further evidence from international developed markets strengthens our empirical findings.