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

  • Bent Jesper Christensen

    ()

    (Aarhus University and CREATES)

  • Morten Ørregaard Nielsen

    ()

    (Queen's University and CREATES)

  • Jie Zhu

    ()

    (Shanghai University of Finance and Economics)

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.

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File URL: http://qed.econ.queensu.ca/working_papers/papers/qed_wp_1295.pdf
File Function: First version 2012
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Paper provided by Queen's University, Department of Economics in its series Working Papers with number 1295.

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Length: 28 pages
Date of creation: May 2012
Date of revision:
Handle: RePEc:qed:wpaper:1295
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