Financial Volatility and the Leverage Effect : A study of the Swedish Stock Exchange

Abstract: In today’s financial markets, volatility is a fundamental concept in regards of the risk assessmentof assets and instruments. Financial volatility is commonly used to measure the quantitativeaspects of risk and is given a significant amount of attention in past literature and research. Theleverage effect refers to the well-established negative relationship between return and futurevolatility. The relation is usually explained by the increased leverage ratio that arises from a dropin the share price for a firm. A lower price means lower value of the equity and while the debtremains unchanged, the leverage ratio will rise. The leverage ratio affect how risky the equity isfrom an investor’s perspective, hence affects the volatility of the stock. This paper aims toanalyse whether the theory is applicable on the Swedish stock exchange and takes bothindividual stocks and the OMXS30-index into account. Further theories related to the model isacknowledged in order to enhance the analysis of the findings. The study is performed by aregression model where volatility, estimated through an EGARCH model, represents thedependent variable. Lagged return, together with a number of control variables, constitutes theexplanatory variables. The findings claims that the leverage effect is present for individual stocksbut can be rejected on the index level. Additionally, significant improvement was noticed when adynamic approach was added to the model. The conclusions drawn is that the Swedish stockexchange facilitates the leverage effect for individual firms but it is off-set by other theories suchas risk-return trade-off and volatility clustering for the index.