Does the Firm-Specific Asset Volatility Process Implied by the Equity Market Revert to a Constant Value?

University of Cambridge, Judge Institute of Management Working Paper No. 11/2004

31 Pages Posted: 21 Feb 2005

See all articles by Elena Medova

Elena Medova

University of Cambridge - Centre for Financial Research; Cambridge Systems Associates Limited

Robert G. Smith

University of Cambridge - Judge Business School

Date Written: 2004

Abstract

In this paper, two structural models where firms have stationary capital structures and endogenous default barriers are extended to allow the principal value of a firm's debt to grow at a constant rate. This allows firms to have a dynamic capital structure. These two models are then used in conjunction with observable equity data to calculate the implied asset volatilities of a sample of fifty firms. Unit root tests are applied to the implied asset volatility and equity volatility processes to determine whether the processes are mean-reverting. Evidence that asset volatility is mean-reverting is found for forty-six of the fifty firms in the sample, regardless of which structural model is used to calculate the asset volatility, while the number of firms whose equity volatility is mean-reverting is in general lower for the poorer credit classes, consistent with the leverage effect. The mean-reversion of asset volatility has implications for the modelling of both equity and debt, and for the pricing of equity options, corporate bonds and credit derivatives.

Keywords: structural credit models, asset volatility, equity volatility

JEL Classification: G10

Suggested Citation

Medova, Elena and Smith, Robert G., Does the Firm-Specific Asset Volatility Process Implied by the Equity Market Revert to a Constant Value? (2004). University of Cambridge, Judge Institute of Management Working Paper No. 11/2004, Available at SSRN: https://ssrn.com/abstract=670125 or http://dx.doi.org/10.2139/ssrn.670125

Elena Medova (Contact Author)

University of Cambridge - Centre for Financial Research ( email )

Centre for Mathematical Sciences
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United Kingdom

Cambridge Systems Associates Limited ( email )

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Robert G. Smith

University of Cambridge - Judge Business School ( email )

Trumpington Street
Cambridge, CB2 1AG
United Kingdom

HOME PAGE: www.jims.cam.ac.uk

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