Extreme Asymmetric Volatility, Leverage, Feedback and Asset Prices

Abstract:     
Asymmetric volatility in equity markets has been widely documented in finance, where two explanations, as considered in Bekaert and Wu (2000), are the financial leverage and the volatility feedback hypothesis. We examine asymmetric volatility for extreme daily U.S. equity returns and VIX changes. To this aim, we model market returns, implied market volatility and volatility of volatility and test for asymmetry in extreme price and volatility changes. Volatility of volatility is found to be asymmetric in that past positive volatility shocks drive positive shocks to volatility of volatility. Our results further document the existence of a significant extreme asymmetric volatility effect, i.e. there is contemporaneous volatility-return dependence for crashes but not for booms. We derive aggregate asset pricing implications of extreme asymmetric volatility, indicating, for example, that under extreme feedback a one-in-a-hundred trading day innovation to average VIX volatility relates to an expected market drop of about 2.5 percent.

Number of Pages in PDF File: 48

Keywords: market volatility, asymmetric volatility, leverage effect, volatility feedback, VIX, market stress, systemic market risk

JEL Classification: C32, G10, G32

working papers series