Title: Application of the Concept of Dissonance to Explain the Phenomenon of Return-Volatility Relationship
Abstract: (ProQuest: ... denotes formulae omitted.)IntroductionTwo important theories that are intended to explain the negative correlation between changes in the volatility and the changes in the stock price are 'leverage theory' and 'volatility feedback theory'. The 'leverage' theory, first propounded by Black (1976), underlines that decrease (increase) of the stock price would cause increase (decrease) of the leverage of the firm. An increased leverage of the firm would increase the risk of the firm, thereby increasing its volatility. A number of empirical studies by Christie (1982), Cheung and Ng (1992), Duffee (1995) and Whaley (2000) support the hypothesis. In other words, the leverage theory predicts that at firm level there would be a negative correlation between changes in volatility and the changes in stock price. However, the leverage theory is not sufficient to explain the phenomenon. For instance, the theory fails to explain return asymmetry in declining and rising market, as also stronger relationship is documented on index return, which as per the theory, should be on individual firm return. On the other hand, the volatility feedback theory considers that volatility is a measure of market risk, and accordingly, if the volatility increases it points to higher risk. With higher risk, the investor would ask for higher return. In order to achieve this higher return, the investors should pay lower price for the stock. Thus, an asymmetric relationship arises between changes in volatility and changes in stock prices. The essential difference between the two theories is that leverage theory suggests that changes in stock price would change volatility and feedback theory implies that changes in volatility would lead to changes in the stock prices. The leverage and the volatility feedback theories have certain drawbacks. In order to overcome these drawbacks, several hypotheses are floated, including the behavioral hypothesis. For instance, an alternate argument put forward in this regard is based on the heterogeneous expectation of risk-averse investors on good news and bad news. The market 'bad news' (responsible for downward movement of stock prices) induces more dominant changes in portfolio composition than changes in the same portfolio as a consequence of 'good news' (responsible for upward movement of stock prices). From another viewpoint, Bouchaud et al. (2011) posit that the price discovery process can be conjectured to be dependent on the moving average of the past prices rather than on the instantaneous price.A fourth view considers volatility as a systematic risk, relevant for pricing decisions. An unexpected increase in volatility increases the risk-adjusted discount rates and under unchanged expectation of cash flow, it tends to decrease the stock prices. The evidences are reported to be positive by Lundblad (2007), while negative and insignificant relationships are reported by Bae et al. (2007) and by Harvey (2001), respectively.Behavioral TheoriesThe hypothesis of Hibbert et al. (2008) suggested a behavioral approach to explain the asymmetrical returns between changes in volatility and changes in return. The concept of affect heuristics1 is cited as a possible reason for negative return-implied volatility relation. In support of this view, the study mentions biding up put prices by the option traders during market downturn due to fear of additional future losses. They also argue on extrapolation bias where past events are used to predict future events. Such activity leads to asymmetric return with respect to put option premium. The study also draws on research findings that market crash arrival rates are higher than rally arrival rates and market crashes are significantly more severe than market rallies. The study concludes that during market crash, there is a legitimate reason for fear potential which increases the implied volatility.There are certain causative behavioral factors which may be responsible for the negative return-positive changes in volatility. …
Publication Year: 2014
Publication Date: 2014-04-01
Language: en
Type: article
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Cited By Count: 1
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