The dynamic power law model

Abstract

I propose a new measure of common, time-varying tail risk for large cross sections of stock returns. Stock return tails are described by a power law in which the power law exponent is allowed to transition smoothly through time as a function of recent data. It is motivated by asset pricing theory and is estimable via quasi-maximum likelihood. Estimates indicate substantial time variation in stock return tails, and that the risk of extreme returns rises in weak economic conditions.