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

66 Pages Posted: 25 Nov 2008 Last revised: 26 Jun 2017

See all articles by Peter Carr

Peter Carr

New York University Finance and Risk Engineering

Liuren Wu

City University of New York, CUNY Baruch College - Zicklin School of Business

Date Written: September 20, 2011

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.

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

Suggested Citation

Carr, Peter P. and Wu, Liuren, Leverage Effect, Volatility Feedback, and Self-Exciting Market Disruptions (September 20, 2011). Bloomberg Portfolio Research Paper No. 2009-03-FRONTIERS; AFA 2011 Denver Meetings Paper; NYU Tandon Research Paper No. 1306495. Available at SSRN: https://ssrn.com/abstract=1306495 or http://dx.doi.org/10.2139/ssrn.1306495

Peter P. Carr

New York University Finance and Risk Engineering ( email )

6 MetroTech Center
Brooklyn, NY 11201
United States
9176217733 (Phone)

HOME PAGE: http://engineering.nyu.edu/people/peter-paul-carr

Liuren Wu (Contact Author)

City University of New York, CUNY Baruch College - Zicklin School of Business ( email )

One Bernard Baruch Way
Box B10-247
New York, NY 10010
United States
646-312-3509 (Phone)
646-312-3451 (Fax)

HOME PAGE: http://faculty.baruch.cuny.edu/lwu/

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