(An) empirical analysis of crash sensitivity and cross-sectional returns in Korean stock market

Abstract

This paper analyzes the impact of lower tail dependence on cross-sectional stock returns in Korean stock market. Lower tail dependence of two random variables is a measure of their co-movement in the lower or negative tail of the distribution. When lower tail dependence is applied to the stock market, it measures the level of co-movement between individual stock return and the market return during extreme market downturns. This measure is utilized to analyze stock investors' crash-averse behavior that market participants hesitate to invest in stocks recording worse returns when market is in recessions. This behavior is justified by the fact that real economic recession and thus consumption and wealth contractions are normally accompanied by the market crash. Lower tail dependence as a proxy of crash sensitivity is used to empirically test whether the lower tail dependence has an impact on individual stock returns. Based on various portfolio analyses and multivariate regressions, this paper shows that the lower tail dependence can partially explain cross-sectional return of stocks in Korea and it amplifies after crash periods.