Time-Varying Crash Risk: The Role of Stock Market Liquidity

66 Pages Posted: 20 Jun 2016 Last revised: 2 Nov 2017

Peter Christoffersen

University of Toronto - Rotman School of Management; Copenhagen Business School; University of Aarhus - CREATES

Bruno Feunou

Bank of Canada

Yoontae Jeon

Ryerson University - Ted Rogers School of Management

Chayawat Ornthanalai

University of Toronto - Rotman School of Management

Date Written: October 2017

Abstract

We estimate a continuous-time model with stochastic volatility and dynamic crash probability for the stock market index and find that market illiquidity dominates other factors in explaining the stock market crash risk. While the crash probability is time-varying, its dynamic depends only weakly on return variance once we include market illiquidity as an economic variable in the model. This finding suggests that the relationship between variance and jump risk found in the literature is largely due to their common exposure to market liquidity risk. Our study highlights the importance of equity market frictions in index return dynamics and explains why prior studies find that crash risk increases with market uncertainty level.

Keywords: Market liquidity, Crash risk, Jump intensity, Options, Filtering

JEL Classification: G01, G12

Suggested Citation

Christoffersen, Peter and Feunou, Bruno and Jeon, Yoontae and Ornthanalai, Chayawat, Time-Varying Crash Risk: The Role of Stock Market Liquidity (October 2017). Rotman School of Management Working Paper No. 2797308. Available at SSRN: https://ssrn.com/abstract=2797308 or http://dx.doi.org/10.2139/ssrn.2797308

Peter Christoffersen

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5P 3C4
Canada
416-946-5511 (Phone)

HOME PAGE: http://www.christoffersen.com

Copenhagen Business School

Solbjerg Plads 3
Frederiksberg C, DK - 2000
Denmark

University of Aarhus - CREATES

School of Economics and Management
Building 1322, Bartholins Alle 10
DK-8000 Aarhus C
Denmark

Bruno Feunou

Bank of Canada ( email )

234 Wellington Street
Ottawa, Ontario K1A 0G9
Canada
613-782-8302 (Phone)

HOME PAGE: http://kamkui.net/

Yoontae Jeon

Ryerson University - Ted Rogers School of Management ( email )

350 Victoria Street
Toronto, Ontario M5B 2K3
Canada

Chayawat Ornthanalai (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

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