Asymmetric Covariance, Volatility and the Impact of News

In this paper we investigate whether or not the conditional covariance between stock and market returns is asymmetric in response to good and bad news. Empirical observations such as the mean reversion of stock prices and asymmetric volatility can be readily explained by time varying risk premiums and it is the link between risk premiums and conditional covariance that we explore. Previous research has focussed on time varying betas but we propose that covariance asymmetry is a more powerful method of explaining such observed behaviour. Our model of conditional covariance accommodates both the sign and magnitude of return innovations and we find significant covariance asymmetry that can explain, at least in part, the mean reversion of stock prices and volatility feedback. We find little evidence in support of the leverage hypothesis of Christie (1982) in explaining asymmetric volatility. The results we obtain appear consistent across firm size, firm leverage, and temporal and cross sectional aggregations