Structural GARCH: The Volatility-Leverage Connection

62 Pages Posted: 21 Apr 2015 Last revised: 28 Oct 2016

See all articles by Robert F. Engle

Robert F. Engle

New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER); New York University (NYU) - Volatility and Risk Institute

Emil Siriwardane

Harvard Business School - Finance Unit

Date Written: October 27, 2016

Abstract

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

Engle, Robert F. and Siriwardane, Emil, Structural GARCH: The Volatility-Leverage Connection (October 27, 2016). Harvard Business School Finance Working Paper No. 16-009, Available at SSRN: https://ssrn.com/abstract=2596622 or http://dx.doi.org/10.2139/ssrn.2596622

Robert F. Engle

New York University (NYU) - Department of Finance

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

New York University (NYU) - Volatility and Risk Institute ( email )

44 West 4th Street
New York, NY 10012
United States

Emil Siriwardane (Contact Author)

Harvard Business School - Finance Unit ( email )

Boston, MA 02163
United States

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