Tuesday, September 3rd @ 11:00-12:30 PM (1011 Evans Hall)
Does the Leverage Effect Affect the Distribution of Return?
Dangxing Chen, UC Berkeley
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, and it has been consistently found in empirical work. However, a few papers have pointed out a puzzle: the return distribution of many assets do not appear to be affected by the leverage effect. We analyze the determinants of the return distribution and find that it is driven primarily by an interaction effect involving both 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&P500 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.