A High-Frequency Investigation of the Interaction between Volatility and DAX Returns

One of the most noticeable stylised facts in finance is that stock index returns are negatively correlated with changes in volatility. The economic rationale for the effect is still controversial. The competing explanations have different implications for the origin of the relationship: Are volatili...

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Bibliographic Details
Published in:European financial management : the journal of the European Financial Management Association 2010-06, Vol.16 (3), p.327-344
Main Authors: Masset, Philippe, Wallmeier, Martin
Format: Article
Language:English
Subjects:
asymmetric volatility
Causality
feed-back effect
Futures
G10
G12
G13
Germany
Granger causality
Granger causality tests
Hypotheses
implied volatility
Impulse response functions
International
leverage effect
Options on stocks
Return on investment
Securities markets
Stock exchange
Stock exchanges
Stock indexing
Stock returns
Studies
Volatility
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Summary:One of the most noticeable stylised facts in finance is that stock index returns are negatively correlated with changes in volatility. The economic rationale for the effect is still controversial. The competing explanations have different implications for the origin of the relationship: Are volatility changes induced by index movements, or inversely, does volatility drive index returns? To differentiate between the alternative hypotheses, we analyse the lead‐lag relationship of option implied volatility and index return in Germany based on Granger causality tests and impulse‐response functions. Our dataset consists of all transactions in DAX options and futures over the time period from 1995 to 2005. Analyzing returns over 5‐minute intervals, we find that the relationship is return‐driven in the sense that index returns Granger cause volatility changes. This causal relationship is statistically and economically significant and can be clearly separated from the contemporaneous correlation. The largest part of the implied volatility response occurs immediately, but we also observe a smaller retarded reaction for up to one hour. A volatility feedback effect is not discernible. If it exists, the stock market appears to correctly anticipate its importance for index returns.
ISSN:1354-7798
1468-036X
DOI:10.1111/j.1468-036X.2008.00459.x