Three Essays on Tail Risk and Volatility Timing


Student thesis: Doctoral Thesis

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Award date12 Aug 2022


This dissertation is composed of three essays. It examines the effect of tail risk on bond offering yield spreads in the U.S. market and the performance of risk managed strategies in the U.S. stock market. In this thesis, I attempt to measure the tail risk by various measurements, and I construct different risk managed strategies to compare their performance. More specifically, this thesis mainly tries to answer three questions: How does the tail risk affect the corporate bond offering yield spreads and credit ratings in the U.S. market? What’s the relationship between bond offering yield spreads and tail risk in U.S. financial institutions? Can risk managed strategies related to profitability earn excess returns in U.S. bank stocks?

The first chapter is a study on the corporate bond spreads, credit ratings, and tail risk in the U.S. primary bond market. It aims to investigate whether the debt market investors understand the underlying tail risk when setting corporate bonds’ prices. By considering the issue-specific features, firm characteristics, and macroeconomic conditions, I show that firms with high tail risk in the equity market also burden higher marginal borrowing costs. When I relate tail risk to the credit rating, the result indicates that tail risk has significant incremental explanatory power to the corporate bond rating. Especially, I use various tail risk measures to confirm the robustness of my results.

The second chapter takes one more step to examine the relationship between bond offering spreads and tail risk in U.S. financial institutions. Because researchers usually regard financial institutions as outliers, there is a lack of related research about financial institutions. And given the importance of the financial sector and its negative externality on the real economy, there is an increasing need to understand financial institutions. I find that bond market investors can correctly recognize and price tail risk, as well as the systematic component of tail risk. The result also indicates that the positive relationship between yield spreads and tail risk is significantly stronger for subordinated bonds and low-rated bonds, as expected. But this relationship is significantly weaker for depository institutions when I separate financial institutions into four categories. In particular, neither total tail risk nor systematic tail risk is priced in subordinated bonds for depository institutions.

In the third chapter, I focus on the bank stocks in the U.S. market. This chapter reveals evidence of the improved performance of risk managed strategies related to profitability. The research methodology applied here is volatility timing, aiming to make risk the same across different trading strategies. It includes three methods, volatility-managed, variance-managed, and dynamic-managed strategies. I find that dynamic strategies significantly outperform volatility-managed and variance-managed strategies, and they all can earn positive and significant excess returns. I also conduct the spanning tests to ensure that my results are robust.