The impact of financial crises on the risk-return tradeoff and the leverage effect

TY - UNPB

T1 - The impact of financial crises on the risk-return tradeoff and the leverage effect

AU - Christensen, Bent Jesper

AU - Nielsen, Morten Ørregaard

AU - Zhu, Jie

PY - 2012

Y1 - 2012

N2 - We investigate the impact of financial crises on two fundamental features of stock returns, namely, the risk-return tradeoff and the leverage effect. We apply the fractionally integrated exponential GARCH-in-mean (FIEGARCH-M) model for daily stock return data, which includes both features and allows the co-existence of long memory in volatility and short memory in returns. We extend this model to allow the financial parameters governing the volatility-in-mean effect and the leverage effect to change during financial crises. An application to the daily U.S. stock index return series from 1926 through 2010 shows that both …financial effects increase significantly during crises. Strikingly, the risk-return tradeoff is significantly positive only during financial crises, and insignificant during non-crisis periods. The leverage effect is negative throughout, but increases significantly by about 50% in magnitude during …financial crises. No such changes are observed during NBER recessions, so in this sense …financial crises are special. Applications to a number of major developed and emerging international stock markets confirm the increase in the leverage effect, whereas the international evidence on the risk-return tradeoff is mixed.

AB - We investigate the impact of financial crises on two fundamental features of stock returns, namely, the risk-return tradeoff and the leverage effect. We apply the fractionally integrated exponential GARCH-in-mean (FIEGARCH-M) model for daily stock return data, which includes both features and allows the co-existence of long memory in volatility and short memory in returns. We extend this model to allow the financial parameters governing the volatility-in-mean effect and the leverage effect to change during financial crises. An application to the daily U.S. stock index return series from 1926 through 2010 shows that both …financial effects increase significantly during crises. Strikingly, the risk-return tradeoff is significantly positive only during financial crises, and insignificant during non-crisis periods. The leverage effect is negative throughout, but increases significantly by about 50% in magnitude during …financial crises. No such changes are observed during NBER recessions, so in this sense …financial crises are special. Applications to a number of major developed and emerging international stock markets confirm the increase in the leverage effect, whereas the international evidence on the risk-return tradeoff is mixed.

KW - FIEGARCH-M, fi…nancial crises, fi…nancial leverage, international markets, long memory, risk-return tradeoff, stock returns, volatility feedback

M3 - Working paper

BT - The impact of financial crises on the risk-return tradeoff and the leverage effect

PB - Institut for Økonomi, Aarhus Universitet

CY - Aarhus

ER -