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