The strategy trades U.S. stocks, ranking by idiosyncratic tail risk from intraday returns, longing high-risk and shorting low-risk deciles, using value-weighted portfolios rebalanced monthly for returns.
ASSET CLASS: stocks | REGION: United States | FREQUENCY:
Monthly | MARKET: equities | KEYWORD: Idiosyncratic, Tail Risk
I. STRATEGY IN A NUTSHELL‘
Rank U.S. stocks by idiosyncratic tail risk using high-frequency intraday returns. Go long on the highest-risk decile and short the lowest-risk decile, value-weighted and rebalanced monthly.
II. ECONOMIC RATIONALE
High idiosyncratic tail-risk stocks earn a premium due to exposure to rare, firm-specific shocks, limits to arbitrage, and intermediary constraints. The premium is persistent and not captured by traditional factor models.
III. SOURCE PAPER
Can the Premium for Idiosyncratic Tail Risk be Explained by Exposures to its Common Factor? [Click to Open PDF]
Liu, Fred, University of Guelph; University of Western Ontario, Department of Economics
<Abstract>
Stocks in the highest idiosyncratic tail risk decile earn 7.3% higher average annual returns than in the lowest. I propose a risk-based explanation for this premium, in which shocks to intermediary funding cause idiosyncratic tail risk to follow a strong factor structure, and the factor, common idiosyncratic tail risk (CITR), comoves with intermediary funding. Consequently, firms with high idiosyncratic tail risk have high exposure to CITR shocks, and command a risk premium due to their low returns when intermediary constraints tighten. To test my explanation, I create a novel measure of idiosyncratic tail risk that is estimated using high-frequency returns, and theoretically establish its time-aggregation properties. Consistent with my explanation, CITR shocks are procyclical, correlated to intermediary factors, priced in assets, and explain the idiosyncratic tail risk premium. Furthermore, volume tail risk also earns a premium, follows a strong factor structure, and its common factor is priced. This duality of idiosyncratic tail risk and volume tail risk provides evidence for my risk-based explanation, and further supports the hypothesis that intermediaries’ large trades cause idiosyncratic tail risk and volume tail risk from Gabaix et al. (2006).
IV. BACKTEST PERFORMANCE
| Annualised Return | 8.21% |
| Volatility | 9.71% |
| Beta | N/A |
| Sharpe Ratio | 0.85 |
| Sortino Ratio | N/A |
| Maximum Drawdown | N/A |
| Win Rate | N/A |
