Increase In Return Volatility Research Articles

Riding the waves: A study of return spillovers and inter-sector linkages in US equity markets during the COVID-19 pandemic

In times of crisis, stock markets experience a significant increase in return volatility, which leads to spillovers across equity sectors. The purpose of this study is to investigate the asymmetric spillovers across ten U.S. equity sectors, representing different industries. Daily prices of sector indices were collected from 02 January 2018 to 22 October 2021 for the analysis. In addition, the study applied Diebold and Yilmaz's (2012) dynamic spillover methodology, along with the static and rolling windows phenomena, to examine the daily returns spillovers across sector indices. The results indicate that 82 % of volatility forecast error variance in U.S sector indices is due to the spillover effect. Moreover, both industrials and financials exhibit the highest gross spillovers to other sectors, while they also receive the highest spillovers from other sectors. Furthermore, the oil and gas sector and utilities sector receive the highest net returns spillovers. These empirical findings provide crucial information regarding the interdependence of U.S. sector indices during the COVID-19 pandemic, which is relevant for investors and practitioners.

The impact of financial speculation on futures contracts price movements: A study of the US markets for dairy commodities

Research background: The study analyzes whether financial speculation destabilizes commodity prices in light of recent price volatility and spikes in agricultural commodities. The study delves deeper into the US dairy futures markets, which are less studied by other authors in their research and relatively new in comparison to other agricultural commodity markets. These dairy commodity futures contracts provide dairy businesses and farmers the chance to hedge against price risks, which are particularly crucial in uncertain economic times such as the post-2020 COVID-19 pandemic timeframe. The analysis makes use of the weekly returns on futures contracts for nonfat milk powder, butter, milk class III, and cheese that are obtained from the Chicago Mercantile Exchange (CME). Purpose of the article: Conduct an empirical study to evaluate the effect of financial speculation on dairy product prices on US commodity markets, including the post-2020 timeframe. Methods: Time series analysis is used in the investigation: the generalized auto-regressive conditional heteroskedasticity (GARCH) method, the Granger causality test, and the Augmented Dickey-Fuller (ADF) test. Findings & value added: Our analysis's findings show that, even though most commodities experienced an increase in return volatility during the post-2020 period, there is no evidence for financial speculation being the cause of increased returns from dairy futures contracts. The research also suggests that financial speculation, in some cases, even lowers the volatility of dairy futures prices. Therefore, non-commercial market participants may help to distribute price risks, making these markets more liquid.

Institutional investors and information acquisition: Implications for asset prices and informational efficiency

We study the joint portfolio and information choice problem of institutional investors who are concerned about their performance relative to a benchmark. Benchmarking influences information choices through two distinct economic mechanisms. First, benchmarking reduces the number of shares in investors' portfolios that are sensitive to private information. Second, benchmarking limits investors' willingness to speculate. Both effects imply a decline in the value of private information. Hence, in equilibrium, investors acquire less information and informational efficiency declines. As a result, return volatility increases and benchmarking can cause a decline in equilibrium stock prices. Moreover, less-benchmarked institutional investors outperform more-benchmarked ones.

Institutional Investors and Information Acquisition: Implications for Asset Prices and Informational Efficiency

We study the joint portfolio and information choice problem of institutional investors who are concerned about their performance relative to a benchmark. Benchmarking influences information choices through two distinct economic mechanisms. First, benchmarking reduces the number of shares in investors’ portfolios that are sensitive to information. Hence, the value of private information declines. Second, benchmarking limits investors’ willingness to speculate. This not only reduces the value of private information but also adversely affects information aggregation. In equilibrium, investors acquire less information and informational efficiency declines. As a result, return volatility increases, and less-benchmarked institutional investors outperform more-benchmarked ones. Received May 31, 2017; editorial decision July 4, 2018 by Editor Stijn Van Nieuwerburgh. Authors have furnished supplementary code, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Ambiguity aversion and optimal derivative-based pension investment with stochastic income and volatility

This paper provides a derivative-based optimal investment strategy for an ambiguity-adverse pension investor who faces not only risks from time-varying income and market return volatility but also uncertain economic conditions over a long time horizon. We derive a robust dynamic derivative strategy and show that the optimal strategy under ambiguity aversion reduces the exposures to market return risk and volatility risk and that the investor holds opposite positions for the two risk exposures. In the presence of a derivative, ambiguity has distinct effects on the optimal investment strategy. More important, we demonstrate the utility improvement when considering ambiguity and exploiting derivatives and show that ambiguity aversion and derivative trading significantly improve utility when return volatility increases. This improvement becomes more significant under ambiguity aversion over a long investment horizon.

Regulatory overkill? Short-sales ban in Korea

Purpose The authors investigate the 2008-2009 short-sales ban in Korea, one of the most comprehensive and restrictive short-selling bans worldwide. The purpose of this paper is to examine: whether the ban stopped a destabilizing effect, if there was any, of short-selling activities; whether the ban improved or deteriorated the informational efficiency or the price discovery process of the stock market; and whether the ban had any impact on market liquidity. Design/methodology/approach Multiple regression; vector autoregression analysis; and generalized autoregressive conditional heteroskedasticity analysis. Findings The authors find no evidence that short-sales have a market-destabilizing effect and thus, restricting short-selling has a market-stabilizing effect. On the contrary, the short-selling ban is associated with an increase in return volatility and a deterioration of the price discovery process, particularly for the stocks without derivatives traded on them. The authors also find evidence of a liquidity decrease for short-sale intensive stocks. However, the evidence is inconclusive as to whether the market efficiency and liquidity changes are solely the result of the short-sales ban or the compound effects of both the ban and the concurrent progress of the financial crisis. Originality/value The literature does not provide a conclusive view on the effects of short-sales or restrictions thereof on the stock market. Also, the existing research on recent worldwide shorting bans often lack empirical scope (e.g. 32 stocks for UK; three weeks for USA). In contrast, the short-sales ban in the Korean stock market, one of the most comprehensive and restrictive short-selling bans worldwide, lasted for eight months for all the listed stocks and is still in effect for financial stocks. The authors find no evidence that short-sales have a market-destabilizing effect and thus, restricting short-selling has a market-stabilizing effect.

Risk-Return Dynamics of the Chinese Stock Market: A Comparison between A, B and H Shares

This study compares the risk-return characteristics of the Chinese A shares with that of B and H shares over the period from January 1995 to June 2012. On average, B and H shares offer a better risk-adjusted return irrespective of whether the returns are measured in the Chinese Yuan (domestic perspective) or in the US dollar (foreign perspective) terms. However, a ‘timeline’ analysis indicates that the relative advantage arising from investment in B or H shares may be nearing the end. This finding appears to be a consequence of investment schemes which allow domestic and foreign investors to cross each other’s territories after opening up of the Chinese market to foreign investors. Second, there is some evidence of exchange rate advantage for foreign investors, even though it is negligible. The results of our study suggest that any additional benefit generated by slight (average annual) appreciation of Yuan against the dollar is offset by an increase in volatility of returns measured in the US dollar.

Duration of Poor Performance, Fund Flows and Risk-Shifting by Hedge Fund Managers

A typical hedge fund manager receives greater compensation when the fund has a strong absolute or relative performance. Asymmetric performance fees and fund flow-performance relationship may create incentives for risk-shifting, estimated in our study by the change in fund return volatility in the middle of the year. However, hedge funds that cannot attract new funds or have had poor performance for a long period may face different incentives. The combination of these two observations confronts hedge fund managers with a complex strategic decision regarding the optimal level of their funds’ return volatility. While an increase in return volatility generally increases the expected payoff of the compensation contract, excessive volatility is not sustainable. This paper empirically examines the factors that affect hedge fund managers’ decisions to risk-shifting. We show that (1) if the fund has had prior poor performance, the magnitude of risk-shifting is larger; (2) as the duration of poor performance increases, risk-shifting is reduced; (3) if the fund is experiencing capital outflows, the magnitude of risk-shifting is smaller and (4) funds that have outflows and also use leverage or have short redemption notice periods display a smaller degree of risk-shifting.

Anchoring Adjusted Capital Asset Pricing Model

An anchoring adjusted Capital Asset Pricing Model (ACAPM) is developed in which the payoff volatilities of well-established stocks are used as starting points that are adjusted to form volatility judgments about other stocks. Anchoring heuristic implies that such adjustments are typically insufficient. ACAPM converges to CAPM with correct adjustment, so CAPM is a special case of ACAPM. The model provides a unified explanation for the size, value, and momentum effects in the stock market. A key prediction of the model is that the equity premium is larger than what can be justified by market volatility. Hence, anchoring could potentially provide an explanation for the well-known equity premium puzzle. Anchoring approach predicts that stock splits are associated with positive abnormal returns and an increase in return volatility. The approach predicts that reverse stock-splits are associated with negative abnormal returns, and a fall in return volatility. Existing empirical evidence strongly supports these predictions.

Summaries of Papers in this Issue

Summaries of Papers in this Issue

Oil Price Shocks and Volatility in Australian Stock Returns

This paper examines the effect of oil shocks on return and volatility in the sectors of Australian stock market and finds significant effects for most sectors. For the overall market index, an increase in oil price return significantly reduces return, and an increase in oil price return volatility significantly reduces volatility. An advantage of looking at sector returns rather than a general index of stock returns is that sectors may well differ markedly in how they respond to oil price shocks. The energy and material sectors (as expected) and the financial sector (surprisingly) are out of step (in different ways) with results for the other sectors and for the overall index. A rise in oil price increases returns in the energy and material sectors and an increase in oil price return volatility increases stock return volatility in the financial sector. Explanation for the negative (positive) association between oil return (oil return volatility) and returns (volatility of returns) in the financial sector must be based on the association via lending to and/or holdings of corporate bonds issued by firms with significant exposure to oil price fluctuations and their speculative positions in oil‐related instruments.

Capital Gains Taxes and Stock Return Volatility

ABSTRACTThis paper presents an empirical investigation of the impact of capital gains taxes on stock return volatility. We predict that the more stock returns are subject to capital gains taxation, the greater the increase in return volatility following a capital gains tax rate cut due to reduced risk-sharing in firms' cash flows between shareholders and the government. Consistent with this prediction, we find larger increases in the return volatility for more appreciated stocks than for less appreciated stocks and for non-dividend-paying stocks than for dividend-paying stocks after both 1978 and 1997 capital gains tax rate reductions. The findings imply that capital gains taxes convey a heretofore overlooked benefit of lower stock return volatility.

Revisiting the incentive effects of executive stock options

We develop a multiperiod framework to evaluate the incentive effects of executive stock options (ESOs). For a given increase in the grant-date firm stock price (and a concurrent increase in return volatility), the increment of total value at the vesting date acts as a proxy for the incentive effects of ESOs. If the option is attached to the existing contract without adjusting cash compensation, we suggest that a firm should not always fix the strike price to the grant-date stock price; instead, the strike price should vary with the length of the vesting period. We also show that, compared with at-the-money options, restricted stock generates greater incentives to increase stock prices in some scenarios, especially when equity-based awards are vested early. If the vesting period is long, the firm could grant options instead of restricted stock to maximize incentives.

Sleeping with the Enemy: Should Investment Banks Be Allowed to Engage in Prop Trading?

This paper investigates whether conflicts of interest exist between the research and proprietary trading departments of full-service investment banks. Using a data set of 11,590 analyst stock recommendations over the period 1999-2007, we find that in the period preceding the Global Research Analyst Settlement (GRAS) sanctioned banks traded ahead of their research reports. Results in the post-GRAS period indicate that sanctioned banks continue to trade ahead of their research reports as institutional ownership in the stock increases and as return volatility increases. The latter result holds only if they also intend to trade against their recommendations after their release. We also find that banks trade against their recommendations for affiliated stocks. Finally, we do not find that the recommendation revision is related to changes in holdings of other investment banks, alleviating concerns that the observed relation is related to common information available to both departments and not to information leakages. Overall, the evidence supports the recent concerns of regulators regarding conflicts of interest that can arise between bank proprietary trading and research departments, highlighting the need for stricter regulation; it is not yet clear whether the Volcker Rule will be successful in addressing this issue.

Fraud and Firm Performance: Evidence from Fraud on the Market and Securities Class Action Lawsuits

We investigate the argument that securities frauds are preceded by surprisingly good firm performance but are followed by rapid negative investor response by studying the longterm stock performance of a sample of 430 firms that disclosed securities fraud and experienced class action lawsuits filed between 1989 and 1999. Estimating Fama-French (F-F) three-factor model-based monthly abnormal returns for three events, alleged fraud commission (FC), fraud disclosure (FD), and initial class action filing (CA), we find significant upward price drift during the five-year pre-FC horizon and weak evidence of a negative drift for up to five years following CA. The observed pre- and post-event abnormal returns cannot be explained by changes in systematic risk (F-F factor loadings), suggesting that the effects of fraud are confined primarily to changes in expected cash flows rather than changes in discount rates. Further, we find positive abnormal trading volume and return volatility during the pre-FC horizon but a significant deterioration in market quality, as evidenced by a persistent negative abnormal drift in relative trading volume and a sustained increase in return volatility, for up to five years following CA.

Capital Gains Taxes and Stock Return Volatility

This paper presents an empirical investigation of the effect of changes in capital gains tax rate on stock return volatility. We focus on two observable cross-sectional variations in the extent to which changes in capital gains tax rate affect return volatility — unrealized capital gains and dividend distributions. For both cross-sectional variations, we predict that the more stock returns are expected to be subject to capital gains taxation, the greater the increase in return volatility following a capital gains tax rate reduction. Consistent with these predictions, after passage of the 1978 and 1997 capital gain tax rate reductions, we find larger increases in the return volatility for more appreciated stocks than for less appreciated stocks and larger increases in the return volatility for non-dividend-paying stocks than for dividend-paying stocks, after controlling for an extensive set of firm characteristics, macroeconomic conditions, domestic and foreign stock market performances.

CEO Compensation and Stock Splits

Do managers perform stock splits to derive personal benefits from them? Given that the authority to carry out a stock split lies largely with the CEO, we wonder what the CEO's personal incentives are to undertake a stock split. We show that the more convex the compensation structure of a CEO, the larger is the likelihood of a stock split. As it is well-documented that stock splits lead to an increase in return volatility, we argue that the likely reason for our finding is that CEOs attempt to increase the value of their option-based compensation component via the stock split. Using data on CEOs' mandatory filings of stock option exercises, we provide further evidence of this strategic behavior by documenting that stock splits predict the exercise of stock options by CEOs.

Measuring Informational Advantage of A Group of Investors

This study interprets various theories of volume of stock markets in a unified DOint of view and classifies the theories into 4 categories: risk premium theory, adverse selection theory, privately informed trading theory, and market stabilization theory. Risk premium theory and adverse selection theory predict that net buying amount of an uninformed trader and future stock return have negative correlation and that ttle correlation approaches-I as current return volatility increases. Privately informed trading theory and market stabilization theory predict that net buying amount of an Informed trader and future stock return have posltive correlation and that the correlation approaches 1 as current return volatility increases. Utilizing these two predictions. this study suggests a method of measuring informational advantage of a group of investors. To measure degrees of Informational advantage of some investor groups in Korean stock market. the method is applied to 7 groups of investors: foreign investors, individual investors. institutional investors, securities companies, Insurers. ITCs, and banks. The result shows that ITCs have the highest degree of informational advant~ age while Individual investors have the lowest level of informational advantage. The fact that this result is consistent with prior researches means that the method suggested in this study has enough empirical validity. This method may be used in a performance evaluation process for a specific fund or a portfolio manager.

Small trades and volatility increases after stock splits

In this paper, we examine the trading activity and return volatility pattern before and after splits. Unlike previous studies, we employ high-frequency transaction data and more powerful asymptotical tests on the impact of split on volatility. Furthermore, we examine the relationship between volatility and volume using different volatility measures and controlling for the effects of autocorrelation and trading costs. We find that small trades increase significantly after stock splits and the increase in return volatility is strongly related to the increase in small trades after stock splits. The results support our contention that the post-split volatility increase is driven primarily by the trading activity of smaller noise investors. Test results are robust to different measures of trading activity and return volatility.

Earnings announcement premia and the limits to arbitrage

We examine the factors underlying the presence of earnings announcement premia. We find that the premia persist beyond the sample period examined in prior studies (ending in 1988), although they decline in magnitude after 1988. Further, premia are lower on the expected than the actual earnings announcement dates. We document that increases in voluntary disclosures result in lower premia, despite the increase in return volatility over time. Finally, our evidence suggests that the premia are not completely eliminated because of the costs of arbitrage.