Leverage Effect, Volatility Feedback, and Self-Exciting Market Disruptions

Abstract:     
The S&P 500 index return interacts negatively with its volatility. This paper traces the negative interaction to three distinct economic channels and proposes to disentangle the relative contribution of each channel using S&P 500 index options. First, equity volatility increases proportionally with the level of financial leverage, the variation of which is dictated by managerial decisions on a company's capital structure based on economic conditions. Second, irrespective of financial leverage, a positive shock to business risk increases the cost of capital and reduces the valuation of future cash flows, generating an instantaneous negative correlation between asset returns and asset volatility. Finally, large, negative market disruptions often generate self-exciting behaviors. The occurrence of one negative disruption induces more disruptions to follow, thus raising market volatility. Model estimation highlights the information in the large cross-section of equity index options in identifying the economic channels underlying the variations of the equity index and its volatility.

Number of Pages in PDF File: 66

Keywords: Option pricing, implied volatility, leverage effect, volatility feedback, self-exciting, market disruptions, jumps, constant elasticity of variance, time-changed Levy processes, Fast Fourier Transform, Gauss-Hermite quadrature, unscented Kalman filter

JEL Classification: F34, G12, G13

working papers series