Changing Risk-Return Profiles

67 Pages Posted: 15 Jun 2018

See all articles by Richard K. Crump

Richard K. Crump

Federal Reserve Banks - Federal Reserve Bank of New York

Domenico Giannone

Federal Reserve Banks - Federal Reserve Bank of New York; Centre for Economic Policy Research (CEPR)

Sean Hundtofte

Federal Reserve Banks - Federal Reserve Bank of New York

Date Written: June 1, 2018

Abstract

We show that realized volatility, especially the realized volatility of financial sector stock returns, has strong predictive content for the future distribution of market returns. This is a robust feature of the last century of U.S. data and, most importantly, can be exploited in real time. Current realized volatility has the most information content on the uncertainty of future returns, whereas it has only limited content about the location of the future return distribution. When volatility is low, the predicted distribution of returns is less dispersed and probabilistic forecasts are sharper. Given this finding on the importance of financial sector volatility not just to financial equity return uncertainty but to the broader market, we test for changes in the realized volatility of banks over a $50 billion threshold associated with more stringent Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) requirements. We find that the equity volatility of these large banks is differentially lower by 9 percentage points after Dodd-Frank compared to pre-crisis levels, controlling for changes over the same period for all banks and all large firms.

Keywords: stock returns, realized volatility, density forecasts, optimal pools, Dodd-Frank, financial intermediation, financial conditions

JEL Classification: C22, G17, G18

Suggested Citation

Crump, Richard K. and Giannone, Domenico and Hundtofte, Sean, Changing Risk-Return Profiles (June 1, 2018). FRB of New York Staff Report No. 850. Available at SSRN: https://ssrn.com/abstract=3197294 or http://dx.doi.org/10.2139/ssrn.3197294

Richard K. Crump (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

Domenico Giannone

Federal Reserve Banks - Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Sean Hundtofte

Federal Reserve Banks - Federal Reserve Bank of New York

33 Liberty Street
New York, NY 10045
United States

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