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Measuring causality between volatility and returns with high-frequency data

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  • Dufour, Jean-Marie
  • García, René

Abstract

We use high-frequency data to study the dynamic relationship between volatility and equity returns. We provide evidence on two alternative mechanisms of interaction between returns and volatilities: the leverage effect and the volatility feedback effect. The leverage hypothesis asserts that return shocks lead to changes in conditional volatility, while the volatility feedback effect theory assumes that return shocks can be caused by changes in conditional volatility through a time-varying risk premium. On observing that a central difference between these alternative explanations lies in the direction of causality, we consider vector autoregressive models of returns and realized volatility and we measure these effects along with the time lags involved through short-run and long-run causality measures proposed in Dufour and Taamouti (2008), as opposed to simple correlations. We analyze 5-minute observations on S&P 500 Index futures contracts, the associated realized volatilities (before and after filtering jumps through the bispectrum) and implied volatilities. Using only returns and realized volatility, we find a weak dynamic leverage effect for the first four hours at the hourly frequency and a strong dynamic leverage effect for the first three days at the daily frequency. The volatility feedback effect appears to be negligible at all horizons. By contrast, when implied volatility is considered, a volatility feedback becomes apparent, whereas the leverage effect is almost the same. We interpret these results as evidence that implied volatility contains important information on future volatility, through its nonlinear relation with option prices which are themselves forwardlooking. In addition, we study the dynamic impact of news on returns and volatility, again through causality measures. First, to detect possible dynamic asymmetry, we separate good from bad return news and find a much stronger impact of bad return news (as opposed to good return news) on volatility. Second, we introduce a concept of news based on the difference between implied and realized volatilities (the variance risk premium) and we find that a positive variance risk premium (an anticipated increase in variance) has more impact on returns than a negative variance risk premium.

Suggested Citation

  • Dufour, Jean-Marie & García, René, 2008. "Measuring causality between volatility and returns with high-frequency data," UC3M Working papers. Economics we084422, Universidad Carlos III de Madrid. Departamento de Economía.
    • Handle: RePEc:cte:werepe:we084422
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    More about this item

    Keywords

    Volatility asymmetry;

    JEL classification:

    • G1 - Financial Economics - - General Financial Markets
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • C1 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General
    • C12 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Hypothesis Testing: General
    • C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Statistical Simulation Methods: General
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods

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