Asymmetric Return Response to Expected Risk: Regulatory Response
14 Pages Posted: 18 Jan 2018
Date Written: January 12, 2018
Purpose: As investors’ fear have an impact on their risk-return tradeoff, this fear leaves markets susceptible to sudden and large fluctuations. Markets develop a long- run normal and regulatory actions should be different for non-normal trading days. Regulators should amend their precautionary methods to recognize the difference in investor behavior for high-risk periods versus low-risk periods.
Design/methodology/approach: We empirically show the difference in investor response to changes in expected risk as a function of level of risk. We then show dif- ferent return patterns for high-risk and low-risk days. Our approach is implemented to evaluate whether Investors’ reaction is the same to changes in risk during high-risk periods versus during low-risk periods.
Findings: The results indicate that the negative return response to incremental increases in risk is significantly higher for periods of high versus low expected risk, with high defined as risk levels above long-run normal.
Research limitations/implications: Investors’ increased response to changes in risk expose financial markets to higher likelihood of sudden and larger fluctuations during high-risk periods. Regulator imposed circuit breakers are designed to protect markets against such market crashes. However, circuit breakers are not designed to account for investor behavior changes. Our results show that circuit breakers should be different for high-risk versus low-risk periods.
Practical implications: A circuit breaker that is designed to protect investors against large drops should be amended to have a lower threshold during high-risk periods.
Originality/value: Our contribution is, to our knowledge, the first research effort to evaluate the effects of differences in investor behavior on investor reactions and regulator imposed fail safes. During the times of extreme market risk, our proposed changes may enable circuit breakers function their intended purposes.
Keywords: Investor behavior, risk aversion, regulatory response, circuit breaker
JEL Classification: G18, G41, G14
Suggested Citation: Suggested Citation