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The Effect of Long Memory in Volatility on Stock Market Fluctuations

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  • Bent Jesper Christensen

    (University of Aarhus and CREATES)

  • Morten Ørregaard Nielsen

    (Cornell University and CREATES)

Abstract

Recent empirical evidence demonstrates the presence of an important long-memory component in realized asset return volatility. We specify and estimate multivariate models for the joint dynamics of stock returns and volatility that allow for long memory in volatility without imposing this property on returns. Asset pricing theory imposes testable cross-equation restrictions on the system that are not rejected in our preferred specifications, which include a strong financial leverage effect. We show that the impact of volatility shocks on stock prices is small and short lived, in spite of a positive risk-return tradeoff and long memory in volatility. Copyright by the President and Fellows of Harvard College and the Massachusetts Institute of Technology.

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  • Bent Jesper Christensen & Morten Ørregaard Nielsen, 2007. "The Effect of Long Memory in Volatility on Stock Market Fluctuations," The Review of Economics and Statistics, MIT Press, vol. 89(4), pages 684-700, November.
    • Handle: RePEc:tpr:restat:v:89:y:2007:i:4:p:684-700
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    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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