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Time-varying Volatility and the Power Law Distribution of Stock Returns

Author

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  • Missaka Warusawitharana

Abstract

While many studies find that the tail distribution of high frequency stock returns follow a power law, there are only a few explanations for this finding. This study presents evidence that time-varying volatility can account for the power law property of high frequency stock returns. The power law coefficients obtained by estimating a conditional normal model with nonparametric volatility show a striking correspondence to the power law coefficients estimated from returns data for stocks in the Dow Jones index. A cross-sectional regression of the data coefficients on the model-implied coefficients yields a slope close to one, supportive of the hypothesis that the two sets of power law coefficients are identical. Further, for most of the stocks in the sample taken individually, the model-implied coefficient falls within the 95 percent confidence interval for the coefficient estimated from returns data.

Suggested Citation

  • Missaka Warusawitharana, 2016. "Time-varying Volatility and the Power Law Distribution of Stock Returns," Finance and Economics Discussion Series 2016-022, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgfe:2016-22
    DOI: 10.17016/FEDS.2016.022
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    File URL: http://www.federalreserve.gov/econresdata/feds/2016/files/2016022pap.pdf
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    References listed on IDEAS

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    Cited by:

    1. Hasan, Rashid & Mohammed Salim, M., 2017. "Power law cross-correlations between price change and volume change of Indian stocks," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 473(C), pages 620-631.

    More about this item

    Keywords

    Tail distributions ; high frequency returns ; power laws ; time-varying volatility;

    JEL classification:

    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • D30 - Microeconomics - - Distribution - - - General
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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