Downside Risk and Asset Returns

In my thesis I study the impact of negative shocks on asset returns. In the first chapter of my thesis I consider statistical measures related to aggregate downside risk. The measures are motivated by economic or extreme event theory and I specifically examine the extent to which market tail risk is priced in the cross section of equity returns. I examine equity returns and show that unconditional asset pricing tests fail to provide evidence in favor of tail risk being priced. However, conditional asset pricing tests reveal the pricing effect of tail risk, suggesting that accounting for time-varying risk premia is important in understanding the asset pricing implications of tail risk.;In the second paper I use information on aggregate downside risk incorporated in credit derivative prices. Using the available market price information about downside risk I show that a factor related to the range of aggregate shocks is a significant determinant of relative equity returns during the financial crisis of 2007-2008. However, for CDS returns I find that the important aggregate shock factor of choice is that related to one very negative shock, namely catastrophe risk.;Finally, in the third paper I examine the flow of information across markets during the financial crisis of 2007-2008. More specifically, I test the hypothesis that increased demand for protection against default of financial firms resulted in an earlier impounding of bad news in the credit-default-swap (CDS) market relative to the equity market. My results are supportive of this hypothesis and are further corroborated by the lack of response in non-financial firms' equity returns to bad news in the CDS market.