49 Pages Posted: 17 Mar 2006
Date Written: January 11, 2007
We develop a new, unlevering approach to document how well financial and operating leverage explain volatility asymmetry on a firm-by-firm basis. Volatility asymmetry means that when stock price drops (rises), the volatility of the returns typically increases (decreases). Our evidence, using a large sample of U.S. firms, shows that almost all of the firm-level asymmetry can be explained by financial leverage and, to a smaller extent, operating leverage. This result is robust even when we allow for risky debt. On the index-level, however, even after removing financial and operating leverage from each component firm, a large portion of volatility asymmetry persists. When the market goes down, unlevered index-level returns have higher volatility because the unlevered component stock returns have higher covariance rather than higher volatility. Covariance asymmetry explains why financial leverage causes the firm-level asymmetry but not the index-level asymmetry.
Keywords: Volatility asymmetry, Financial leverage, Operating leverage, Covariance asymmetry, Merton model, Stock returns
JEL Classification: G12
Suggested Citation: Suggested Citation
Daouk, Hazem and Ng, David T., Is Unlevered Firm Volatility Asymmetric? (January 11, 2007). AFA 2007 Chicago Meetings. Available at SSRN: https://ssrn.com/abstract=891596 or http://dx.doi.org/10.2139/ssrn.891596