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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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  1. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "This Time Is Different: Eight Centuries of Financial Folly," Economics Books, Princeton University Press, edition 1, volume 1, number 8973, April.
  2. Breidt, F. Jay & Crato, Nuno & de Lima, Pedro, 1998. "The detection and estimation of long memory in stochastic volatility," Journal of Econometrics, Elsevier, vol. 83(1-2), pages 325-348.
  3. Bollerslev, Tim, 1986. "Generalized autoregressive conditional heteroskedasticity," Journal of Econometrics, Elsevier, vol. 31(3), pages 307-327, April.
  4. Christensen, Bent Jesper & Nielsen, Morten Ørregaard & Zhu, Jie, 2010. "Long memory in stock market volatility and the volatility-in-mean effect: The FIEGARCH-M Model," Journal of Empirical Finance, Elsevier, vol. 17(3), pages 460-470, June.
  5. Gara Afonso & Anna Kovner & Antoinette Schoar, 2010. "Stressed, not frozen: the Federal Funds market in the financial crisis," Staff Reports 437, Federal Reserve Bank of New York.
  6. Robinson, P. M., 2001. "The memory of stochastic volatility models," Journal of Econometrics, Elsevier, vol. 101(2), pages 195-218, April.
  7. Bent Jesper Christensen & Morten Ørregaard Nielsen, 2007. "The Effect of Long Memory in Volatility on Stock Market Fluctuations," CREATES Research Papers 2007-03, School of Economics and Management, University of Aarhus.
  8. Matt P. Dziubinski & Stefano Grassi, 2012. "Heterogeneous Computing in Economics: A Simplified Approach," CREATES Research Papers 2012-15, School of Economics and Management, University of Aarhus.
  9. Yu, Jun, 2005. "On leverage in a stochastic volatility model," Journal of Econometrics, Elsevier, vol. 127(2), pages 165-178, August.
  10. Campbell, John Y. & Hentschel, Ludger, 1992. "No news is good news *1: An asymmetric model of changing volatility in stock returns," Journal of Financial Economics, Elsevier, vol. 31(3), pages 281-318, June.
  11. Changli He & Annastiina Silvennoinen & Timo Teräsvirta, 2005. "Parameterizing Unconditional Skewness in Models for Financial Time Series," Research Paper Series 169, Quantitative Finance Research Centre, University of Technology, Sydney.
  12. Gara Afonso & Anna Kovner & Antoinette Schoar, 2010. "Stressed not Frozen: The Fed Funds Market in the Financial Crisis," NBER Working Papers 15806, National Bureau of Economic Research, Inc.
  13. Bollerslev, Tim & Zhou, Hao, 2006. "Volatility puzzles: a simple framework for gauging return-volatility regressions," Journal of Econometrics, Elsevier, vol. 131(1-2), pages 123-150.
  14. Anders Bredahl Kock & Laurent A.F. Callot, 2012. "Oracle Inequalities for High Dimensional Vector Autoregressions," CREATES Research Papers 2012-16, School of Economics and Management, University of Aarhus.
  15. Bollerslev, Tim & Ole Mikkelsen, Hans, 1996. "Modeling and pricing long memory in stock market volatility," Journal of Econometrics, Elsevier, vol. 73(1), pages 151-184, July.
  16. Baillie, Richard T. & Bollerslev, Tim & Mikkelsen, Hans Ole, 1996. "Fractionally integrated generalized autoregressive conditional heteroskedasticity," Journal of Econometrics, Elsevier, vol. 74(1), pages 3-30, September.
  17. Ding, Zhuanxin & Granger, Clive W. J., 1996. "Modeling volatility persistence of speculative returns: A new approach," Journal of Econometrics, Elsevier, vol. 73(1), pages 185-215, July.
  18. Anders Bredahl Kock, 2013. "Oracle inequalities for high-dimensional panel data models," CREATES Research Papers 2013-20, School of Economics and Management, University of Aarhus.
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