Asymmetric return response to expected risk: policy implications
| DOI | https://doi.org/10.1108/JFRC-01-2018-0004 |
| Pages | 345-356 |
| Published date | 18 June 2019 |
| Date | 18 June 2019 |
| Author | Mehmet F. Dicle,Kendra Reed |
| Subject Matter | Financial risk/company failure,Accounting & Finance |
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 investors’fearhas an impact on their risk-return tradeoff, this fearleaves markets susceptible
to sudden and large fluctuations. 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 investors’reaction 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 significantly
higher for periods of high versus low expected risk, with high defined as risk levels above long-run normal.
Research limitations/implications –Investors’increased response to changes in risk exposes
financial markets to higher likelihoodof sudden and larger fluctuations 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 authors’knowledge, the first 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 financial markets bear the risk of turning into a market crashes or even
financial crises. The 2010 “flash crash”sank 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 fluctuations; “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 influence on the market and build investor confidence. (Subrahmanyam,
2013,p.7)
JEL classification –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
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