Measuring Tail Risks in Real Time

I develop a new methodology for measuring expected tail risks using the cross section of bid-ask spreads. Market makers embed tail risk information into spreads, because (1) middlemen lose to arbitrageurs when sharp price movements exceed the cost of liquidity and (2) price movements and potential costs are linear in factor loadings. Using this insight, simple cross-sectional regressions relating spreads and trading volume to factor betas can recover factor tail risks in real time for priced or non-priced return factors. The recovered time series of implied market risks aligns closely with both realized market jumps and the VIX. In addition, the methodology quantifies a sharp, temporary increase in market tail risk before and throughout the 2010 Flash Crash; anticipates jump risks associated with Federal Open Market Committee announcements; and disentangles financial and aggregate market risks during the 2007-2008 Financial Crisis.