WESTERN KENTUCKY UNVIERSITY

Have the Stock Volatility Changed over the 2008 Financial Crisis?
A research on stock beta and R-squared at industry level
Linh Dao 5/10/2011

Dr. Alex Lebedinsky Department of Economics

Have the stock volatilities changed over the 2008 financial crisis? Linh Dao

Abstract This paper uses a specific-to-general approach to assess the volatility of all common stocks at the industry level. During the period from Jan 1st 2002 to April 25th 2011, a sample of 15 sectors prices were collected (using SAS and Yahoo Finance) and analyzed according to their beta and R-squared. In order to study the changes throughout the period because of market condition, the entire sample was split into 2 smaller time periods (before and after the financial crisis November 2008). Accordingly, there have been noticeable increases in R-squared and a significant growth of beta over the crash of the stock market. The result refers to shift in asset allocation and portfolio management due to the changes in individual stocks correlations with market movement and the effect of diversification. The research also signals defensiveness and aggressiveness of every single industry to the extent that the particular industry should maintain that level of covariance with the entire market based on its distinguishable features and characteristics. Introduction Inspired by a recent study of John Y. Campbell, Martin Lettau, Burton G. Malkiel and Yexiao Xu Have individual stocks become more volatile - An empirical exploration of idiosyncratic risk, this research simplifies the process of collecting data and analyzing only at the industry level which is sufficient enough for a general regression. As opposed to the study, the research does take individual firms beta into consideration and solely use for the purposes of running a huge amount of regression. The research uses a similar methodology to analyze

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Have the stock volatilities changed over the 2008 financial crisis? Linh Dao

data which will be explained thoroughly. The results obtained strongly support our forecast and arguments before conducting the research.

Methodology A large data set of 4927 stocks in the entire market is created for the purpose of the research. The whole sample consisting of 4927 ticker symbols is used to gather relevant information about prices and returns over the period. By using certain specific SAS codes, the amount of time spent on collecting data was significantly reduced. Separate files for every industry are created to avoid statistical errors and improve the overall accuracy of the regression. Also, S&P500 was chosen to be the benchmark at the index level of the research. The S&P 500 returns are downloaded from finance.yahoo.com along with the 3-month Treasury bill rates retrieved from research.stlouisfed.org in order to calculate risk premiums for the whole sample. The most time-consuming part deals with combining all files and stacking the entire stock samples returns and risks on top of each other to facilitate the analysis. The combined file is then sorted by date and industry accordingly before being processed in the regression. For the purpose of calculating beta, the research uses the Capital Asset Pricing Model (CAPM) to take advantage of the risk premiums obtained. The result of the whole samples regression is then classified according to pre- and post-crisis period. Result Interpretation

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Have the stock volatilities changed over the 2008 financial crisis? Linh Dao

The ultimate results of the whole sample strongly support pre-research forecast. Figure 1.1 shows that Auto Tires Truck is the most market-related sector with highest beta (1.569) and a greatest amount of variation (0.815). As up to 23.6% on average of individual stocks movements within the sector are explained by market changes, Auto Tires Trucks stands out to be the one that highly responds to index activities. Technology remains fairly volatile with excessive beta of 1.414. However, only 18.5% variation of the sector is due to the effect of systemic risk which makes the sector, to some extent, even harder to actively manage Technology stocks within the portfolio. Also, certain companies within the industry does not actually follow market changes which results in the minimum R-squared of 0 obtained in the regression. Therefore, the notion of risk-return tradeoff was strengthened through the research. Utilities is still showing a defensive picture as the only sector with beta less than 1. Even though up to 19.4% of sub-sector stocks movement is a direct result of market changes, Utilities tends to reduce the range of fluctuations. Among 15 sectors being analyzed, the claimed-to-be-defensive Medical sector surprisingly top estimates by the highest amount of variation between individual companies beta and alpha (the amount of excess return of the firm when market risk premium is 0). Based on this result, abnormal returns can now be seen in several Medical stocks which are not so much different from highly risky technology stocks. In general, all other sectors ended up with predicted results (beta from 1.0 to 1.3 and R-squared around 18%). Apparently, individual stocks can be affected by any market activities. The 2008 financial crisis are no exception. Interestingly, the research discovers a close relation between the crash of the market and how almost all of sectors beta and R-squared responded to the event.
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Have the stock volatilities changed over the 2008 financial crisis? Linh Dao

A noticeable downward trend can be witnessed in firms betas. Figure 1.2 shows that 12 of 15 sectors magnified the correlation with the market by having their post-crisis betas increased by approximately 33% in comparison with pre-crisis data. A stabilized market was formed with lower amount of risks closely related to the standard deviation of basic material, energy, finance, consumer staple and even technology stay below the average of 0.758 after 2008. Medical, once again, stands out as the potential investment sector with an excessive amount of risk (5 times higher standard deviation) which also refers to the huge probability of abnormal returns. For investors seeking for growth and plenty amount of risk-return, Medical now seems ideal. On the other hand, several sectors (auto, business service, construction, energy, retail, consumer discretionary and consumer staple) ended up with higher standard deviation. This effect is likely to deal with the fact that these sectors mostly facilitate the process of recovery after crisis; due to the considerable higher demand of these sectors business function the stock reasonably follow a more active trend. There was a significant growth in R-squared of all sectors over the crisis. Figure 1.3 shows that on average, R-squared went up sharply by 125% with the highest percentages belong to energy, basic material and transportation (236%, 166% and 150% respectively). It is reasonable to state that these necessities of the economic condition on recovery phase tend to follow market changes more closely. However, the standard deviation of all stocks prices performance or the amount of total risks associated with the companies also increased by approximately 56% on average. Energy, again, acquired 110% more risks over the crisis period the largest growth of standard deviation of R-squared among all sectors. In general, although

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Have the stock volatilities changed over the 2008 financial crisis? Linh Dao

individual stocks move together with the market in a more consistent manner, they also carry greater portions of risk that would result in reduced advantage of portfolio diversification. In conclusion, the economy after the 2008 financial crisis generally benefit investors with a more stabilized and predictable market. Individual stocks within the sector tend to respond more to the market movement and to be controlled more by market factors. Further research the firm and index level would certainly provide a much more insightful appreciation of the entire stock market.

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Have the stock volatilities changed over the 2008 financial crisis? Linh Dao

Appendix

Figure 1.1: Whole Sample result

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Have the stock volatilities changed over the 2008 financial crisis? Linh Dao

Figure 1.2: Beta before and after the financial crisis

Figure 1.3: R-squared before and after the financial crisis

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