Impulse Response Functions and Causality Test of Financial Stress and Stock Market Risk Premiums

Abstract

Using the vector autoregression (VAR) analysis, this study empirically documents the impulse response functions of financial stress and market risk premiums and performs a causality test of these two variables. The analysis of the monthly changes of the Federal Reserve Bank of St. Louis Financial Stress Index and excess returns on the CRSP value-weighted index from 1994:2 to 2012:5 shows that market risk premiums become negative in the first, second and third, fourth and twelfth months following the financial stress shock. The degree of financial stress drops in the first, second, fourth, fifth, seventh, tenth months following risk premium shock. There is no observed feedback response from financial stress to market risk premium shock. The Granger causality test results show that financial stress Granger-causes market risk premiums to drop significantly, and there is no reverse causation recorded in this case. In addition, the time-varying OLS regression analysis shows a statistically significant negative coefficient (b = -8.50; t = -9.20) when explanatory variable is the monthly changes in financial stress.

Keywords: financial distress, market risk premiums

JEL Classification: G20, G12, G14