Extreme Downside Risk in Asset Returns

Financial markets can experience sudden and extreme downward movements. Investors are highly concerned about the performance of their assets in such scenarios. Some assets perform badly in a downturn in the market; others have milder reactions. The assets that react mildly are desirable and should sell at a premium. But determining how reactive individual stocks are to extreme market downturns is a difficult task given the small sample of these events.

This paper uses a simple methodology to measure the sensitivity of individual stocks to extreme market movements. I count the number of times the market and the individual stock simultaneously pass their individual extreme threshold. I divide the number of these occurrences by the number of times the market is extreme. This measure can be seen as the probability that the asset value will have an extremely negative reaction when the market experiences an extremely negative episode.

By sorting individual stocks based on this measure and analyzing the direction and increase in the average return of the sorted stocks, I measure the compensation investors demand for exposure to this risk. I find that investors demand a 3.5 percent risk premium for investing in a stock with high sensitivity to the market relative to one with low sensitivity. This measure characterizes the riskiness of a stock not captured by existing risk factors.