Predicting Financial Crisis by Examining Risk-Return Relationship

Abstract

We test the risk-return relationship in and around the global financial crisis for three market groups namely developed, emerging and frontier markets, from June 2005 to June 2016. Four risk proxies are used viz. Standard Deviation, Semi Deviation, Beta and Downside Beta. We find that the global financial crisis had a de-coupling effect as the return associations between global financial markets declined for the post crisis period. We also observe high positive correlations between alternative risk measures implying that asset pricing tests shall be robust to choice of risk measure. Next, we find that the risk-return relationship is absent in the pre-crisis period while it is significantly negative in the post crisis period using standard deviation based measures. Thus, the breaking down of risk-return relationship may be an important predictor of any forthcoming crisis. Further, global capital markets seem to behave like distressed economies in the post crisis period and, hence, exhibit option like behavior. We re-verify our hypothesis by using data in and around the Asian Crisis Period and confirm the absence of risk-return relationship prior to the crisis period. The study contributes to capital market literature with special emphasis on financial crisis.