Extreme Dependence Structures and the Cross-Section of Expected Stock Returns

Abstract

This paper examines whether investors receive compensation for holding crash-sensitive stocks. We capture the crash sensitivity of stocks by their lower tail dependence (LTD) with the market based on copulas. We find that stocks with weak LTD serve as a hedge during crises, but, overall, stocks with strong LTD have higher average future returns. This effect cannot be explained by traditional risk factors and is different from the impact of beta, downside beta, coskewness, and cokurtosis. Our findings are consistent with results from the empirical option pricing literature and support the notion that investors are crash-averse.