BERND PAPE Asset Allocation, Multivariate Position Based Trading ...

30 ACTA WASAENSIAThe leverage hypothesis seems also an unlikely explanation since Engle & Lee (1993)found the asymmetric volatility response to stock price changes to be a transitoryeffect only. For example, Gallant et al. (1993) find that the leverage effect becomesinsignificant after 5—6 days at index level and Tauchen et al. (1996) find a similar declineat individual stock level already after 2—3 days 30 .Butfirms are unlikely to adjust theircapital structure that fast to the original level of financial leverage 31 .Also,iffinancialleverage was the true explanation for volatility asymmetry, then issue of debt and stockshould be associated with a corresponding leverage effect as well; this has however notbeen found 32 .A competing explanation for the leverage effect is the so called Volatility Feedback hypothesis,according to which an increase in stock market volatility raises required stockreturns, and thus lowers stock prices. It has also originally been proposed by Black(1976) 33 and termed such and empirically tested by Campbell & Hentschel (1992), whohowever find that volatility feedback has only little effect on returns.Volatility feedback is also rejected in the studies by Bouchaud & Potters (2001) andBouchaud et al. (2001) on high frequency returns, which find a negative correlationonly between past returns and future volatility, but not the other way round. Bouchaudet al. (2001) manage to explain the leverage effect for individual stocks within a “retardedvolatility” model in which price innovations at intraday frequency are assumedto be proportional to a moving average of past prices rather than the most recent price;buttheexplanationoftheleverageeffect at the index level requires the ad-hoc introductionof an additional “market panic” factor, whose existence remains theoreticallyunmotivated in their study.As such, the economic mechanism behind the leverage effectremainsanunsolvedissue.30 Exponential dampening of the leverage effect with slower decay for indexes than for individualstocks has been recently confirmed even for high frequency data, see Bouchaud & Potters (2001);Bouchaud, Matacz & Potters (2001); Litvinova (2003). They also confirm a finding originally notedby Braun et al. (1995), that the magnitude of the leverage effect appears to be stronger at marketthan at individual stock level.31 For related findings regarding adjustment of the capital structure to earnings-induced leveragevariations, see Ball, Lev & Watts (1976).32 see Figlewski & Wang (2000).33 similar ideas are expressed e.g. in Malkiel (1979) and Pindyck (1984).