The Impact of Equity Tail Risk on European Markets

Abstract

I apply a dynamic equity tail risk variable to equity and government bond returns in Europe, understanding how investors react upon an increase in market uncertainty, departing from a risk aversion premise. I show that tail risk has predictive power for market returns, but less significantly than in the US. Nevertheless, the cross-sectional analysis provides evidence that investors demand a higher return from stocks that co-move more with tail risk, and the government bond analysis demonstrates that the yield-to maturity of safer bonds decreases upon an increase in equity tail risk, a sign of investors’ flight to safety, in uncertain times.