Connectedness among stocks and tail risk: Evidence from China

Applying the market tail risk measure proposed by Kelly and Jiang in the China's A-shares market, we find that the monthly market tail risk significantly and negatively predicts the monthly industrial output growth rate up to 1 year. In addition, from July 2007 to June 2019, we find that stocks with a higher tail risk outperform stocks with a lower tail risk by 0.62% (0.30% after risk adjustment) per month. Using the institutional holding weight within an industry and correlations in return on assets as proxies for the connectedness among stocks associated with firm fundamentals, and treating the sentiment risk and correlations in the three factor risk-adjusted residuals as proxies for the connectedness among stocks associated with investor sentiment, we further show that the connectedness among stocks significantly affects individual stocks' tail risk and tail risk premium. Moreover, our findings show that the connectedness components of tail risk associated both with firm fundamentals and with investor sentiment can significantly and positively predict stock returns. Our finding suggests that the connectedness among stocks provides an important channel through which firm fundamentals and investor sentiment influence the tail risk premium in the China's A-shares market.