Is tail risk the missing link between institutions and risk?

Groslambert, Betrand and Basu, Devraj and Lai, Wan-Ni (2019) Is tail risk the missing link between institutions and risk? Economics Bulletin, 39 (2). pp. 1435-1448. ISSN 1545-2921

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    Abstract

    This paper examines the link between risk and institutional quality, an unresolved issue in finance. Our hypothesis is that institutions affect risk through extreme events and not through volatility. We focus on relative tail risk with an original approach that is able to estimate historical tail risk with greater precision. Using international stock market data, we show that tail risk is stable over time, unlike volatility. We find that tail risk captures the relation between risk and institutional quality better than volatility. Better governance substantially reduces the probability of extreme events.