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Is Unlevered Firm Volatility Asymmetric

Is Unlevered Firm Volatility Asymmetric - Is Unlevered Firm...

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Electronic copy of this paper is available at: http://ssrn.com/abstract=891596 Is Unlevered Firm Volatility Asymmetric? By Hazem Daouk Cornell University David Ng 1 Cornell University This version: January 11, 2007 Abstract 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. JEL Classification: G12 Keywords: Volatility asymmetry; Financial leverage; Operating Leverage; Covariance asymmetry. 1 Both authors are from the Department of Applied Economics and Management, Cornell University, Ithaca, NY 14853. Their email addresses are: [email protected] and [email protected] , respectively. We thank Utpal Bhattacharya, David Brown, Anchada Charoenrook, Tim Crack, Robert Dittmar, Robert Hodrick, Craig Holden, Robert Jennings, Dan Jubinski, Sreenivas Kamma, Josef Lakonishok, Jun Pan (the AFA discussant), Lasse Pedersen, Richard Shockley, Albert Wang, Xiaoyan Zhang, Guofu Zhou, seminar participants at Amsterdam, Cornell, California Riverside, Cincinnati, Illinois, Maryland, Oklahoma, Queen’s, Washington University, the American Finance Association meeting, the Western Finance Association meeting, the CRSP forum and the Frank Batten Young Scholars Conference for helpful discussions and comments. We thank Ajay Palvia and Jiyoun An for excellent research assistance. Remaining errors are our own.
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Electronic copy of this paper is available at: http://ssrn.com/abstract=891596 1 Traditionally, asymmetric volatility is explained by financial leverage effect (Black (1976) and Christie (1982a)). Asymmetric volatility refers to the stylized fact that stock volatility rises when price drops and drops when price rises. The financial leverage hypothesis explains that as the price of a stock decreases, the firm’s financial leverage increases, leading to a higher volatility of equity. Indeed, this leverage effect explanation is so dominant that it has become synonymous with asymmetric volatility.
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