On downside risk predictability through liquidity and trading activity: A dynamic quantile approach

Most downside risk models implicitly assume that returns are a sufficient statistic with which to forecast the daily conditional distribution of a portfolio. In this paper, we analyze whether the variables that proxy for market-wide liquidity and trading conditions convey valid information for forecasting the quantiles of the conditional distribution of several representative market portfolios, including volume- and value-weighted market portfolios, and several Book-to-Market- and Size-sorted portfolios. Using dynamic quantile regression techniques, we report evidence of conditional tail predictability in terms of these variables. A comprehensive backtesting analysis shows that this link can be exploited in dynamic quantile modelling, in order to considerably improve the performances of day-ahead Value at Risk forecasts.