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The Effect of Long Memory in Volatility on Stock Market Fluctuations

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  • Bent Jesper Christensen
  • Morten Ørregaard Nielsen

    (School of Economics and Management, University of Aarhus, Denmark)

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 trade-off and long memory in volatility.

Suggested Citation

  • Bent Jesper Christensen & Morten Ørregaard Nielsen, 2007. "The Effect of Long Memory in Volatility on Stock Market Fluctuations," CREATES Research Papers 2007-03, Department of Economics and Business Economics, Aarhus University.
    • Handle: RePEc:aah:create:2007-03
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    More about this item

    Keywords

    Financial leverage; long memory; realized volatility; risk-return trade-off; stochastic volatility; stock prices; VARMA models; VIX implied volatility.;
    All these keywords.

    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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