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Journal ArticleDOI

Why Does Stock Market Volatility Change Over Time

01 Dec 1989-Journal of Finance (JOURNAL OF FINANCE)-Vol. 44, Iss: 5, pp 1115-1153
TL;DR: The authors analyzes the relation of stock volatility with real and nominal macroeconomic volatility, economic activity, financial leverage, and stock trading activity using monthly data from 1857 to 1987, finding that stock return variability was unusually high during the 1929-1939 Great Depression.
Abstract: This paper analyzes the relation of stock volatility with real and nominal macroeconomic volatility, economic activity, financial leverage, and stock trading activity using monthly data from 1857 to 1987. An important fact, previously noted by Officer (1973), is that stock return variability was unusually high during the 1929-1939 Great Depression. While aggregate leverage is significantly correlated with volatility, it explains a relatively small part of the movements in stock volatility. The amplitude of the fluctuations in aggregate stock volatility is difficult to explain using simple models of stock valuation, especially during the Great Depression. ESTIMATES OF THE STANDARD deviation of monthly stock returns vary from two to twenty percent per month during the 1857-1987 period. Tests for whether differences this large could be attributable to estimation error strongly reject the hypothesis of constant variance. Large changes in the ex ante volatility of market returns have important negative effects on risk-averse investors. Moreover, changes in the level of market volatility can have important effects on capital investment, consumption, and other business cycle variables. This raises the question of why stock volatility changes so much over time. Many researchers have studied movements in aggregate stock market volatility. Officer (1973) relates these changes to the volatility of macroeconomic variables. Black (1976) and Christie (1982) argue that financial leverage partly explains this phenomenon. Recently, there have been many attempts to relate changes in stock market volatility to changes in expected returns to stocks, including Merton (1980), Pindyck (1984), Poterba and Summers (1986), French, Schwert, and Stambaugh (1987), Bollerslev, Engle, and Wooldridge (1988), and Abel (1988). Mascaro and Meltzer (1983) and Lauterbach (1989) find that macroeconomic volatility is related to interest rates. Shiller (1981a,b) argues that the level of stock market volatility is too high relative to the ex post variability of dividends. In present value models such as Shiller's, a change in the volatility of either future cash flows or discount rates

Summary (2 min read)

Reistions between Stock Market Volatility and the Volatility of Macroeconomic Variables

  • The conditional variance of the stock price at time t-l, Vari(P).
  • In fact, several analysts have noted that the volatility of macroeconomic variables changes over time.
  • Table 3A contains tests of the incremental ptedictive power of 11 lags of FF1 inflation volatility jrj in a 12th order vector autoregressive (VAR) system for stock volatility, high-grade bond return volatility tht'' and short-term interest volatility 'Crt' , that allows for different monthly intercepts.

It

  • Figures 4a, 4b and 4c contain plots of the predicted volatility of the growth rates of industrial production of bank clearings I2dcI) and of liabilities of business failures I2ftI respectively.
  • Romer[1986b] argues that data collection procedures cause part of the higher volatility of this series before 1929.
  • Both World War I and World War II led to moderate increases in volatility, and volatility was higher during the 1929-1940 period.
  • In the mid.l9tF century, the only banks in the sample were in New York City.

Predicted Volatility of Real Growth

  • Predicted Volatility of Real Growth increments, currently covering virtually all commercial banks.
  • The annual cross correlations between industrial production volatility and stock volatility are positive in Table 2C .
  • Table 5 shows that volatility is higher during recessions, since most of the estimates are positive and none is more than 1.5 standard errors below 0. Section 5 addresses this question directly.

4. Stock Volatility and Corporate Profitability

  • For the other sample periods, the intercept a0 is less than the slope 01 a result that is inconsistent with all of the leverage models.
  • The t-test in the last column of Table 8 tests the hypothesis that the slope equals the intercept.
  • The p-value in parentheses is for the two-sided alternative hypothesis.
  • Many of the estimates of a1 are reliably g:eater than zero, showing that an increase in the debt/equity ratio leads to an increase in stock return volatility.
  • Nevertheless, none of the t-statistics in the last column is greater than .67.

5.2 Stock Market Trading and Volatility

  • The analysis of the volatility of bond tetumns, inflation rates, money growth, and teal mactoeconomic variables, along with stock volatility, seeks to decetaine whethet these aggregate volatility measures change together thtough tire.
  • Jn most general equilibrium models, fundamental factors such as consumption and production opportunities and preferences would determine all of these parameters (e.g., Abel[1988] or Cenotte and Marah [1987] ).
  • Nevertheless, the process of characterizing stylized facts about economic volatility helps define the set of interesting questions, leading to tractable theoretical models.

6.1 Joint Effects of Leverage and Macroeconomic Volatility

  • Percent increase in long-term corporate bond return volatility.
  • Note that this result is not limited to the post-1979 period when both short and longterm interest rates exhibited unusual volatility.
  • Thus, the results in Table 10 suggest that macroeconomic volatility has differential effects on the volatility of corporate stock and bond returns.

6.2 Synthesis

  • 2Obviously, this overstates March debits, since the holidays were intended to slow down the rate of financial transactions during this period.
  • These series are spliced together using the average ratio of the respective series during 1960.
  • Thus, the base data since 1960 are multiplied by viii.

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NBER WORKING PAPER SERIES
WHY DOES STOCK MARKET VOLATILITY CHANGE OVER TIME?
C. William
Schwert
Working Paper
No. 2798
NATIONAL BUREAU OF ECONOMIC RESEARCH
1050
Massachusetts Avenue
Cambridge,
MA 02138
December 1988
Discussions with Ken French and Rob
Stambaugh
have contributed
significantly
to this
paper.
I received
helpful
comments
from Fischer
Black, Harry
DeAngelo,
Ken
French,
Dan
Nelson,
Charles
Plosser,
Paul
Seguin,
Jerold
Zimmerman and seminar
participants
at Yale
University,
and
at the Univer-
sities of
Chicago, Michigan,
Rochester and
Washington.
The
Bradley Policy
Research
Center at the
University
of
Rochester
provided support
for this
research. This research is
part
of NBER's
program
in Financial Markets and
Monetary
Economics.
Any opinions expressed
are those of the author not those
of the National Bureau of Economic
Research.

NBER
Working Paper
#2798
December
1988
WHY DOES STOCK MARKET VOLATILITY CHANGE OVER TIME?
ABSTRACT
This
paper analyzes
the relation of
stock
volatility
with real and nominal
macroeconomic
volatility,
financial
leverage,
stock
trading activity,
default
risk,
and firm
profitability using
monthly
data from 1857-1986. An
important
fact, previously
noted
by
Officer[l973],
is that stock return
variability
was
unusually
high during
the
1929-1940 Great
Depression.
Moreover,
leverage
has
a
relatively
small effect on stock
volatility.
The
amplitude
of the fluctuations
in
aggregate
stock
volatility
is difficult to
explain
using
aimple
models of
stock valuation.
G.
William Schwert
William E. Simon Graduate School
of Business Administration
University
of Rochester
Rochester,
NY 1462]

Wlfl DOES STOCK MARKET VOLATILITY
ChANCE OVER TIME?
C. William
Schwert
1.
Introduction
Many
researchers have
noted that
aggregate
atock market
volatility changes
over time.
Officer[l973]
relates these
changes
to the
volatility
of
macroeconomic
variables.
Black[197g]
and
Christie(l982] argue
that financial
leverage
explains
some of this
phenomenon.
Recently,
there have been
many
attempts
to relate
changes
in stock market
volatility
to
changes
in
expected
returns to
stocks, including
Mertonl9gO]
,
Pindyck[l984]
,
Poterba and
Susssers(l9SSJ, French,
Schwert and
Stambaugh[l987, Eollerslev, Engle
and
Wooldridge[l9Sg]
,
Cenotte and
Marsh[1987)
,
and
Abel[lSgg]
Shiller[l98la,l9glb] argues that
the level of stock market
volatility
is
too
high
relative
to the ex
post
variability
of
dividends
in the context of a
simple present
value model.
In
present
value models such as
Shiller's,
a
change
in the
volatility
of either future cash flows
or discount rates causes a
change
in
the
volatility
of stock returns.
There have been
many
critiques
of Shiller's
work,
notably
Kleidon[1986].
Nevertheless,
no one has
analyzed
the relation
between time-variation in stock
return
volatility
and fundaisental determinants
of value.
This
paper
characterizes the
changes
in
stock market
volatility
through
time.
In
particular,
the
goal
is to
relate stock market
volatility
to
the
time-varying volatility
of
a
variety
of economic vsriables. Relative
to the
1857-1986
period, volatility
was
unusually high
from 1929-1940 for
many
economic
series, including
inflation, money growth,
industrial
production,
and

other measures of economic
activity.
I find evidence that stock market
volatility
increases with financial
leverage,
as
predicted by
Black
and
Christie,
although
this factor
explains only
a small
part of the
variation in
stook market
volatility.
In
addition,
interest rate and
corporate
bond return
volatility
is correlated
with stock return
volatility. Finally,
stock market
volatility
increases
during
recessions and is relsted
to
measures
of
corporate
profitability.
None of these
factors,
however,
plays
a dominant role in
explaining
the behavior
of stock
volatility
over time.
Section
2
describes
the time series
properties
of the
data and
the
empirical strategy
for
modeling rime-varying volatility.
Section 3
analyzes
the relations of stock and bond return
volatility
with the
volatility
of five
important
macroeconomic
variables. Section 4 studies the relation between
stock market
volatility
and
corporate
profitability.
Section 5
analyzes
the
relation
between financial
leverage
and stock return
volatility,
and the
relation between stock
market
trading activity
and
volatility.
Finally,
section 6
synthesizes
the results from the
preceding
sections and
presents
concluding
remarks.
2. Time Series
Properties
of
the
Data
The
Appendix
describes
the sources used to construct the data
in
this
paper.
Table 1 lists these
variables. There are measures of;
stock
returns
(Stock).
short
(Int)
and
long-term
bond
yields
and returns
(Nibond
and
Medbond).
inflation
monetary growth
(Baser).
aggregate
real economic
activity
(IP, Fail
and
Bank).
financial
leverage
(S/Vs).
dividend
(D/F)
and
earnings yields
for
stocks,
and stock market
trading activity,
including
the
growth
rate of share
trading
volume
(Volume)
and
the
number of
trading days per
month
(Days).
The measure of stock
marker
volatility
based

Table 1
Monthly
Variables Used in This
Paper
Sample
Period,
Series Size
Stock
Monthly
return
to a
value-weighted portfolio
of New
2/1857
-
12/1986
York Stock
Exchange stocks(CRSP/Cowles/Macaulay)
T-.1559
Volatility
of returns to Standard & Poor's
composite 1/1926
-
12/1986
index (Ftench,
Schwert and
Stambaugh)
T—732
mt Short-term interest rate on low risk
debt
instrument
1/1857
-
12/1986
(GRSP/Macaulay)
T—1560
Nibond Yield or rerurn on
high-grade long-term
1/1857
-
12/1986
corporate
debt
(Moody's Aa/Macaulay)
T—l560
Medbond Yield or return on
medium-grade long-term
1/1919
-
12/1986
cotporate
debt
(Moody's
Baa)
T—8l6
PPI Inflation of
producer price
index
for all
2/1862
-
12/1986
commodities
(BLS/Macaulay)
T—1499
Base Growth rate of
monetary
base
(high-powered money) 7/1878
-
12/1986
(Friedman
&
Schwartz/NBER/Fedecal
Reserve)
T—l302
IP Grovth rate of the index of industrial
production 2/1889
-
12/1986
(seasonally adjusted
-
Federal
Reserve)
T—1l75
Bank Growth rate of bank
clearings
or debits
1/1854
-
12/1986
(Macaulay/Federal Reserve)
T—l560
Fail Growth rate of liabilities of business failures
2/1875
-
3/1986
(Dun
and
Bradstreet)
T—l335
S/V
Market value of stock divided
by
firm value for
1/1900
-
12/1986
S&P
composite index(Nolland
and
Myers)
T—1044
Volume NYSE share
trading
volume
(SEP/NYSE) 4/1881
-
12/1986
T—l268
Days
Number of NYSE
trading days pet
month
(S&P)
1/1928
-
12/1986
T—708
D/P
Dividend
yield
for Standard & Poor's
composite
index
1/1871
-
12/1986
(S&P/Cowles)
T—l392
E/P Earnings yield
for Standard &
Poor's
composite
index
1/1871
-
12/1986
(S&P/Gowles)
T—1392

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  • ...…Boudoukh, Richardson and Whitelaw (1997), Brailsford and Faff (1996), Canina and Figlewski (1993), Dimson and Marsh (1990), Frennberg and Hansson (1995), Figlewski (1997), Heynen and Kat (1994), Jorion (1995), Lamoureux and Lastrapes (1993), Schwert (1989, 1990a) and Schwert and Seguin (1990)....

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  • ...Intraday Returns and Interdaily Volatility Forecast Evaluation The computation of daily return variances from high-frequency intraday returns parallels the use of daily returns in calculating monthly ex-post volatility, as exemplified by Schwert (1989, 1990a) and Schwert and Seguin (1990)....

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