Asymmetric covariance, volatility and time-varying risk premium: Evidence from the Finnish stock market

Abstract

It appears that stock return and its volatility are negatively correlated. Negative returns cause volatility to increase more than positive returns of the same magnitude. This empirical regularity is often termed as asymmetric volatility in the burgeoning literature. Two competing theoretical explanations for observed volatility asymmetry at the firm level have been put forward by researchers: leverage effect, and volatility feedback effect (i.e., time-varying risk premia). Using a more up-to-date data in the context of the Finnish stock market, the thesis aims to investigate observed volatility asymmetry within the framework of volatility feedback effect. In other words, the study examines asymmetric behavior of conditional variances and covariance, and their impact on risk premium under the time-varying risk premium hypothesis. The research contributes to the extant literature on the volatility asymmetry under the volatility feedback effect in the context of the Finnish stock market since most previous studies were based on other developed stock markets. Apart from studies under volatility feedback effect in the Finnish stock market, it is the only study concentrating directly on volatility feedback effect to explain observed volatility asymmetry. Hence, the study provides valuable insights into the return-volatility dynamics and their asymmetric functioning to practitioners as well as investors. The analysis is approached employing econometric models such as univariate EGARCH, ADCC-EGARCH in modeling conditional covariance. The results suggest that market conditional volatility increases expected stock risk premium through a change in covariance, and so does more when market return is asymmetric. The findings reveal that evidence for volatility feedback effect to explain observed volatility asymmetry is weak. Rather, evidence for significant firm-specific conditional volatility is found. The study puts forward reasons for firm-specific conditional volatility is due to firm-level leverage, and/or market inefficiency. The results provide practical implications and insights for potential investors and portfolio managers regarding the benefits of investing and diversifying portfolio in the Finnish stock market.