Does the Leverage Effect Affect the Return Distribution?

26 Pages Posted: 4 Oct 2019

See all articles by Dangxing Chen

Dangxing Chen

University of California, Berkeley - Consortium for Data Analytics in Risk

Date Written: September 18, 2019

Abstract

The leverage effect refers to the generally negative correlation between the return of an asset and the changes in its volatility. There is broad agreement in the literature that the effect should be present for theoretical reasons, and it has been consistently found in empirical work. However, a few papers have pointed out a puzzle: the return distributions of many assets do not appear to be affected by the leverage effect. We analyze the determinants of the return distribution and find that the impact of the leverage effect comes primarily from an interaction between the leverage effect and the mean-reversion effect. When the leverage effect is large and the mean-reversion effect is small, then the interaction exerts a strong effect on the return distribution. However, if the mean-reversion effect is large, even a large leverage effect has little effect on the return distribution. To better understand the impact of the interaction effect, we propose an indirect method to measure it. We apply our methodology to empirical data and find that the S&P 500 data exhibits a weak interaction effect, and consequently its returns distribution is little impacted by the leverage effect. Furthermore, the interaction effect is closely related to the size factor: small firms tend to have a strong interaction effect and large firms tend to have a weak interaction effect.

Keywords: Leverage effect, Stochastic volatility, Size, Risk

JEL Classification: G11, C58

Suggested Citation

Chen, Dangxing, Does the Leverage Effect Affect the Return Distribution? (September 18, 2019). Available at SSRN: https://ssrn.com/abstract=3456254 or http://dx.doi.org/10.2139/ssrn.3456254

Dangxing Chen (Contact Author)

University of California, Berkeley - Consortium for Data Analytics in Risk ( email )

United States

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
31
Abstract Views
275
PlumX Metrics