Structural GARCH: The Volatility-Leverage Connection

Robert Engle and Emil N. Siriwardane

The Review of Financial Studies, 2018, vol. 31, issue 2, 449-492

Abstract: In the aftermath of the financial crisis, institutions have been asked to reduce leverage in order to reduce risk. To address the effectiveness of this measure, we build a model of equity volatility that accounts for leverage. Our approach blends Merton’s insights on capital structure with traditional time-series models of volatility. We estimate that precautionary capital needs for the entire financial sector reached $2 trillion during the crisis. We also investigate the long-standing observation that equity volatility asymmetrically responds to positive and negative news. Volatility asymmetry is mostly explained by exposure to the aggregate market, not a mechanical leverage effect. Received March 27, 2015; editorial decision February 25, 2017 by Editor Andrew Karolyi.

Date: 2018
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Working Paper: Structural GARCH: The Volatility-Leverage Connection (2014)
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