Financial Sector Volatility Connectedness and Equity Returns

Abstract

The objective of this study is to analyze how financial connectedness impacts equity markets and potentially raises the cost of equity for firms that are more dependent on the financial sector. We apply the Diebold and Yilmaz (2014) methodology to daily stock prices of the largest 40 U.S. financial institutions to construct a volatility connectedness index. We find that there is a large statistically significant difference between the returns of non-financial firms with positive and negative exposures to this index. The four- factor alpha of a strategy that goes long in the bottom decile and short in the top decile of stocks sorted on their connectedness betas is roughly 15% per annum. Based on bivariate portfolio tests and Fama-MacBeth return regressions, abnormal returns are robust to market beta, size, book-to-market ratio, momentum, profitability, asset growth, debt, illiquidity, idiosyncratic volatility and downside beta. They are, however, driven by smaller firms whose returns covary negatively with the index. These firms tend to be of low credit quality which explains their dependence on financial institutions.