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Extreme Risk, excess return and leverage: the LP formula

Abstract : The LP formula is based upon the substitution of the exogenous risk aversion hypothesis by a credit equilibrium hypothesis. This leads to a trade-off between expected blue-sky return – the expected return excluding default scenarios – and extreme risk estimated from scenarios leading to default. An empirical study on the past 90 years shows that this trade-off curve is almost identical across asset classes. In equilibrium, an asset expected blue-sky return is proportional to its contribution to extreme risk. Assuming normal returns, we obtain CAPM as a sub-case of the LP relation. This relationship makes extreme risk underestimation a strong driver of asset price bubbles.
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Submitted on : Tuesday, May 12, 2015 - 5:41:21 PM
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  • HAL Id : hal-01151376, version 1

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Olivier Le Marois, Julia Mikhalevsky, Raphaël Douady. Extreme Risk, excess return and leverage: the LP formula. 2014. ⟨hal-01151376⟩

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