Structural GARCH: The Volatility-Leverage Connection
62 Pages Posted: 21 Apr 2015 Last revised: 28 Oct 2016
Date Written: October 27, 2016
During the financial crisis, financial firm leverage and volatility both rose dramatically. Consequently, institutions are being asked to reduce leverage in order to reduce risk, though the effectiveness depends upon the role of capital structure in volatility. To address this question, we build a statistical model of equity volatility that accounts for leverage. Our approach blends Merton’s insights on capital structure with traditional time-series models of volatility. Using our model we quantify how capital injections impact the risk of financial institutions and estimate firm specific precautionary capital needs. In addition, the longstanding observation that volatility is more responsive to negative shocks than positive is shown to be less a consequence of actual leverage than it is of risk premiums.
Keywords: GARCH, Leverage, Credit Risk, Systemic Risk, SRISK, Structural Models of Credit, Leverage Effect
Suggested Citation: Suggested Citation