Asymmetric return response to expected risk: policy implications

Author:Mehmet F. Dicle, Kendra Reed
Position:College of Business, Loyola University New Orleans, New Orleans, Louisiana, USA
Pages:345-356
SUMMARY

Purpose As investors’ fear has an impact on their risk-return tradeoff, this fear leaves markets susceptible to sudden and large fluctuations. The purpose of this study is to suggest regulators to amend their precautionary methods to recognize the difference in investor behavior for high-risk periods versus low-risk periods. Design/methodology/approach The authors empirically... (see full summary)

 
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Asymmetric return response to
expected risk: policy implications
Mehmet F. Dicle and Kendra Reed
College of Business, Loyola University New Orleans, New Orleans,
Louisiana, USA
Abstract
Purpose As investorsfearhas an impact on their risk-return tradeoff, this fearleaves markets susceptible
to sudden and large uctuations. The purpose of this study is to suggest regulators to amend their
precautionary methodsto recognize the difference in investor behavior for high-riskperiods versus low-risk
periods.
Design/methodology/approach The authors empirically show the differencein investor response to
changes in expected risk as a functionof level of risk. They then show different return patterns for high-risk
and low-risk days. Their approach is implemented to evaluate whether investorsreaction is the same to
changesin risk during high-risk versus low-risk periods.
Findings The results indicate that the negative return response to incremental increases in risk is signicantly
higher for periods of high versus low expected risk, with high dened as risk levels above long-run normal.
Research limitations/implications Investorsincreased response to changes in risk exposes
nancial markets to higher likelihoodof sudden and larger uctuations during high-risk periods. Regulator-
imposed circuit breakers are designed to protect markets against such market crashes. However, circuit
breakers are not designed to account for investor behavior changes.The results show that circuit breakers
should be differentfor high- versus low-risk periods.
Practical implications A circuit breaker that is designed to protect investors against large drops
should be amendedto have a lower threshold during high-risk periods.
Originality/value The contributionis, to the authorsknowledge, the rst research effort to evaluate the
effects of differences in investorbehavior on investor reactions and regulator imposed fail-safes. During the
times of extreme market risk, the proposed changes may enable circuit breakers function their intended
purposes.
Keywords Risk aversion, Investor behavior, Circuit breaker, Regulatory response
Paper type Research paper
Introduction
Fluctuations in the nancial markets bear the risk of turning into a market crashes or even
nancial crises. The 2010 ash crashsank Dow Jones Industrial Average almost a
thousand points.Easley et al. (2011) provide possible explanations for such a crash,including
possible regulatory responses to such high and sudden market drops including circuit
breakers. Subrahmanyam (2013) provides a detailed review of the circuit breakers and their
usefulness against exacerbating market uctuations; In sum, the bulk of the literature has
not found solidevidence that circuit breakersreduce or increase volatility(p.7). Further:
Given the experience with the crash there is a compelling case to be made for circuit breakers that
would act as a calming inuence on the market and build investor condence. (Subrahmanyam,
2013,p.7)
JEL classication G18, G41, G14
Asymmetric
return
response
345
Received12 January 2018
Revised26 June 2018
Accepted29 August 2018
Journalof Financial Regulation
andCompliance
Vol.27 No. 3, 2019
pp. 345-356
© Emerald Publishing Limited
1358-1988
DOI 10.1108/JFRC-01-2018-0004
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1358-1988.htm

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