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The Impact Of Financial Crises On The Risk-return Tradeoff And The Leverage Effect

Author

Listed:
  • Bent Jesper Christensen

    (University of Aarhus and CREATES)

  • Jie Zhu

    (University of Aarhus and CREATES)

  • Morten Ø. Nielsen

    (Queen's University and CREATES)

Abstract
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.

Suggested Citation

  • Bent Jesper Christensen & Jie Zhu & Morten Ø. Nielsen, 2012. "The Impact Of Financial Crises On The Risk-return Tradeoff And The Leverage Effect," Working Paper 1295, Economics Department, Queen's University.
    • Handle: RePEc:qed:wpaper:1295
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    8. Christensen, Bent Jesper & Nielsen, Morten Ørregaard & Zhu, Jie, 2015. "The impact of financial crises on the risk–return tradeoff and the leverage effect," Economic Modelling, Elsevier, vol. 49(C), pages 407-418.
    9. Jia, Yun & Yang, Chunpeng, 2017. "Disagreement and the risk-return relation," Economic Modelling, Elsevier, vol. 64(C), pages 97-104.
    10. Ashraf, Dawood & Felixson, Karl & Khawaja, Mohsin & Hussain, Syed Mujahid, 2017. "Do constraints on financial and operating leverage affect the performance of Islamic equity portfolios?," Pacific-Basin Finance Journal, Elsevier, vol. 42(C), pages 171-182.
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    More about this item

    Keywords

    FIEGARCH-M; financial crises; financial leverage; international markets; long memory; risk-return tradeoff; stock returns; volatility feedback;
    All these keywords.

    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • G01 - Financial Economics - - General - - - Financial Crises

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