Why are Stock Returns and Volatility Negatively Correlated?

Abstract

The literature documents that low stock returns are associated with increased volatility, but two competing explanations have proved difficult to disentangle. A negative return increases leverage making equity value more volatile. However, volatility feedback increases the risk premium when a surprise rise in volatility is expected to persist. We follow Bekaert and Wu (2000) in controlling for leverage, but distinguish between volatility regimes that persist from less persistent changes using GARCH. Supporting volatility feedback, we find changes in volatility regime are reflected in stock returns, but not GARCH. Further, variation in leverage is not important in explaining volatility dynamics.

Keywords: Asymmetric volatility, volatility reedback, leverage effect, regime switching, GARCH

JEL Classification: C32, C51, G12