Tlrc Munchester School Supplement 19%

0025-2034 83-103

VOLATILITY, LEVERAGE AND FIRM SIZE:

THE U.K. EVIDENCE

bY
PATRICIA L.CHELLEY-STEELEY
Queen Mary and Westfeld College,
University of London
and
JAMES M.STEELEYt
Bank of England

I INTRODUCTION
It has long been known that portfolios or indexes that gave greater weight
to small capitalization firms were characterized by greater serial correlation
than portfolios or indexes that gave little weight to small firms; see, for
example, the seminal paper by Fisher (1966) and the studies of the empirial
application of the Capital Asset Pricing Model by Scholes and Williams
(1977) and Dimson (1979). Recently, Lo and MacKinlay (1990), in a study
ofu.S. stock market data, pointed out that this was not the ody difference
between the serial correlations of size-based portfolio returns. They system-
atically documented the structure of cross-serial correlations between the
portfolio returns. They found that while the past returns of a portfolio of
large firms were strongly correlated with the current return of a portfolio of
small firms, the reverse was not the case. This discovery was enhanced by
the work of Conrad et a[. (1991) who found, again for the U.S. equity
market, that unexpected returns to large firm portfolios were important
&terninants of the current Volatility and returns of small h s , but that the
reverse was not the case.
The aim of this paper is to examine whether there are similar asym-
metries in the dynamics ofthe returns of size-basedportfolios of U.K. stocks
and to extend the search for size-related regularities to the leverage effect.
m e leverage effect (see Black, 1976, and Christie, 1982) refers to the
tendency for returns and volatility to be negatively correlated. That is,
negative returns are more likely to be associated with greater volatility than
positive returns. In this paper, we seek to determine whether the leverage

thy views expressed arc those of the authors alone. For helpful comments, we me Fateful
to Gary Xu; the anonymous referees;participantsat the 1995 MMF COnfenna in
in particular Mike Wickcns and Keith Cuthbertson, and at the 1995 Financial
Management Association Conference in New York; and seminar participants at
the ~ M F - N o r t hWest meetings. Warwick Business School, and the Department of
Accounting and Finance at the universityof Manchester.
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83
 84 The Manchester School

effect is influenced by firm size and whether the choice between alternative
models of the variance of U.K. equity returns is conditional on firm size.
In Section 11, we describe the framework that is used to model the time
series behaviour of the volatility of the portfolio returns series. We distin-
guish between models where there are asymmetric transfers of volatility
between portfolios and where there are asymmetric transfers of volatility
within portfolios. In Section 111, we describe the data used in this study and
provide some summary statistics regarding the portfolio returns series. In
Section IV,we report the results obtained from modelling the volatility of
the portfolio returns series using the alternative specifications described in
Section 11. Section V contains a discussion of the main findings and offers
some conclusions.

I1 ALTERNATIVE
MODELS
OF THE CONDITIONAL OF PORTFOLIO
VARIANCE
RETURNS
We use the GARCH family of statistical processes to model the conditional
mean and variance of the returns to capitalization-rankedportfolios. These
processes, developed by Engle (1982) and generalized by Bollerslev (1 986),
have been successfully applied across a wide range of financial variables. A
recent survey is provided by Bollerslev et al. (1992). Previous work on
modelling U.K.stock market volatility at the level of aggregate stock
market indices is well represented by Poon and Taylor (1992). Our focus will
be at the level of portfolios of securities, where the component securities
are grouped according to their market capitalization.

The Univariate Model

The univariate model underlying the two particular specifications con-
sidered in this paper is the following ARMA(1,l)-GARCH(1,l)-M
specification:

where&i,rI Qr-1 N(O, hi,,),

h , r = mi + b&-1+ cihl,,-l (2)
where Ri,r is the return on portfolio i in week t,
mt > 0, bi,ci L 0, bi +q < 1
and Rr-1 is the set of all available information at time t - 1.
In equation (l), portfolio returns are modelled as an ARMA(1,l)
process, with a GARCH-M term. The ARMA( 1 , I ) model is parsimonious
and appeared to be well specified for all the portfolio returns series. We have
used an extension of the GARCH model, the GARCH-in-Mean
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 Volatility,Leverage and Finn Size 85
(GARCH-M) model suggested by Engle, Lilien and Robins (1987), which
allows the conditional mean to be a function of the contemporaneous con-
ditional variance. Such a specification has been applied successfully in
empirical tests of the Capital Asset Pricing Model; see, for example,
Bollerslev, Engle and Wooldridge (1988). However, we have not imposed
any such equilibrium model on the mean equation. Moreover, we have
investigated capitalization-based portfolios and not the market portfolio.
ow inclusion of the GARCH-M term can be seen as an attempt to
determine whether the information contained in the conditional variance is
important in determining estimates of the conditional mean returns. This is
particularly interesting when shocks from other portfolios are included in
the conditional variance specification.
Equation (2) is known as a GARCH(1,l) specification. In this model,
the coefficient bi measures the impact of past squared unexpected returns on
the current conditional variance of the returns, while the coefficient ci
measures the impact of the past conditional variance on the current con-
ditional variance; that is, the collective impact of all past shocks to the
volatility. Given bi, ci 2 0, a large shock to the variance in this period will
increase the variance in the next period, thereby increasing the chance of a
large shock in the next period. Moreover, as (bi ci) + 1, the impact of+
these shocks becomes more Persistent. These features capture the findings of
Mandelbrot (1963) and Fama (1969 that large price changes tend to be
followed by large price changes, and small changes by small changes, of
either sign. Recently, a number of studies have shown that a GARCH(1,l)
process models conditional variances adequately; see Bollerslev et al.
(1992).

me Volatility Spillover Model

m e idea of examining Volatility spillovers was pioneered by H m a o et al.
(lggo), who considered the influence of stock market volatility in one
country on the behaviour of the volatility and returns of the stock market in
another country. To examine the issue of volatility spillovers, we adopt their
two-stage procedure. First, we estimate the univariate ARMA( 1,l)-
GARCH( 1, I)-M model for each portfolio, equations (I) and (2). Second,
we introduce the l a s e d squared errors for portfolioj , i.e., the squared m-
expected return, as an explanatory variable in the conditional variance
equation for Portfolio i. The COeffiCkIltSof the following augmented model
are then estimated:
&,r = CL,+ Pihi,, + W t - 1 + Ei,t - 6iei,t-, i, j = 1,2,3,4, (3)
where 8t.t I 4 - 1 - N(O, hi,r),
hi,, = mi + b&-l + Cih.t-1 + ki,,&l j #i (4)
 86 The Manchester School

where the coefficient k,, measures the impact of past return shocks to
portfolio j on the conditional volatility of portfolio i. Other terms are as
previously defined. This model has been used by Conrad et al. (1991) to
examine the spillovers of volatility among portfolios of U.S.equities, also
sorted by capitalization. They found that significant volatility shocks
tended to transfer from portfolios containing relatively large firms to
portfolios containing relatively small firms, but that there was no signifi-
cant evidence of shocks transferring in the opposite direction. They
characterized this feature as an asymmetric transfer of volatility between
portfolios. The model in the next section considers a different kind of
volatility asymmetry.

The Asymmetric Volatility Model

The relationship between volatility and the sign of stock price movements
is a part of the folklore of stock markets. It is usually claimed that the r e
lationship has a negative sign. When the stock price decreases, the volatility
increases, and vice verso. This phenomenon has been called the leverage
effect since it can be explained in terms of the financial leverage of the
company; see, for example, Black (1976) and Christie (1982). Increases in
financial leverage increase both the required return and the risk of equity.
The increase in required rate of return induces a decrease in the stock price,
which gives the negative relationship between stock price movements and
volatility,
The isolation of the impact of the sign of the shock to volatility can be
achieved by the following re-specification of the conditional variance model,
equations (1) and (2):
Ri,r = pi + Pihi,, + 4,Ri,r-1 + &i,t - fli&j,t-l i, j = 1,2,3,4 (5)
where et,r I Q-1 ‘Y N(O, hiJ,

where R,,, is the return on portfolio i in week r, and Rr-I is the set of all
available information at time t - 1. In this specification, the past squared
volatility shock appears twice; on its own, and with a multiplicative
“indicator” dummy variable. This variable takes the value unity if the past
return was negative and the value zero otherwise. Thus, the coefficient di
measures whether the sign of the return influences the conditional variance.
If the coefficient is positive, it indicates that a negative shock will have a
greater impact on future volatility than a positive shock; that is, there exists
a leverage effect.
A number of alternative models to capture the leverage effect have been
suggested, such as the exponential GARCH,or EGARCH, model of Nelson
(1991), the asymmetric GARCH,or AGARCH, model of Engle and Ng
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 Volatility,Leverage and Firm Size
, 87
(1993) and the “indicator” model of Glosten, Jagannathm and
(1993) used here. We examined all of these specificationsand, in addition, a
modification of a conditional variance model using absolute residuals which
was suggested by Taylor (1986). In line with Engle and Ng (1993) who
compared the specificationsmentioned earlier, we obtained slightly different
results in each case. Since Engle and Ng independently recommended the
L‘indicator’’ model as the parametric model most able to a p t w e a s p -
metries, we report those particular results here.’ From our viewpoint, they
are representative and conservative.

111 DATA
A N D SWMARY STATISTICS

we calculated weekly returns for four size-based portfolios of U.K. stocks

spanning the period from January 1976 to December 1991, providing a t h e
series of 834 observations for each portfolio. In January of each year stocks
that traded throughout that year were assigned to one of the fourportfolios
on the basis of their capitalization. Capitalization data were obtained from
the London Share Price Database. Stocks were selected at random until each
portfolio contaifled 50 stocks each year. As this process used the stock
return data of more than 400 companies, the portfolio returns series will
provide a very broad characterization of the behaviour of the U.K.stock
market over time. Weekly stock returns were calculated as the change in the
logarithm of closing prices ofsuccessiveWednesdays:
rt = In (PA - In Pt-I ) (7)
obtained from Datastream.? Weekly portfolio returns were calculated as
an equally-wei&ted average of the weekly returns of the component
stocks,
 88 The Manchester School

Table 1 contains summary statistics for weekly returns, squared

returns, and absolute returns for the four equally-weightedportfolios. There
are striking differences among the autocorrelations of the portfolio returns
and these appear to be related to the capitalizationranking of the portfolio.
The portfolios of relatively small firmstend to have return autocorrelation
coefficients that are greater than those for portfolios of relatively larger
firms. Although for all portfolios the magnitudes of the autocorrelation
coefficients decay at higher orders, more than half of the reported CO-
efficientsare statistically significant. All of the portfolios have significant
first- and second-order autocorrelation and all of the reported coefficients
for the small firm portfolio are significant.
In Table 2, we report the estimated cross-serial correlations between
the returns of portfolios and find a similar pattern to that documented by Lo
and MacKinlay (1990) for the U.S.stock market. The leading diagonal
terms in the sections of this table correspond to the autocorrelations
reported in Table 1, The terms above the diagonal tend to be larger than the
corresponding terms below the diagonal. This means that there is a stronger
correlation between the past returns of relatively large firm portfolios and
the current returns of relatively small firm portfolios than exists in the
opposite direction. For example, the previous week’s return of the large firm
portfolio and the current return of the small firm portfolio are correlated
at 38 per cent. In contrast, the previous week’s return of the small firm
portfolio and the current week’s return of the large firm portfolio are
correlated at only 9 per cent. As with the autocorrelations, the cross-serial
correlationsdecay as the lag length increases.
Table 1 also reports the autocorrelation coefficients of both squared
and absolute returns. A similar pattern to that observed for the underlying
returns series can be identified. The small firm portfolio has greater auto-
correlation than the large firm portfolio in both squared and absolute
returns. Autocorrelation coefficients are generally smaller as the lag length
increases. But, in contrast to the autocorrelation observed for the underlying
returns series, the coefficientsfor squared and absolute returns are generally
much larger at lags 1 and 2. First-order autocorrelation coefficients for
squared returns are 60 per cent and 43 per cent for the small firm portfolio
and large firm portfolio, respectively. As explained by Granger and
Anderson (1978), strong autocorrelation in squared and absolute returns is
a symptom of changing unconditional or conditional variances. In partic-
ular, these results suggest that the volatility of small firm portfolio returns is
more clustered than the volatility of large firm portfolio returns; that is,
large absolute returns are more likely to be followed by large absolute
returns than by small absolute returns.
By formally modelling the variance of portfolio returns we may deter-
mine whether other volatility characteristics such as persistence and the
leverage effect are linked to firm size. Our modelling framework has the
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 Volatility, Leverage and Firm Sue 89
advantage of allowing the volatility to be conditioned upon the auto-
correlation and crossautocorrelation structure documented above, which is
itself related to firm size.

IV RESULTS
me Volatility Spillover Model
For each portfolio, the spillover model, equations (3) and (4), is estimated
four times: once without spillovers and three times with volatility spillover
effects from each of the other portfolios in turn. Maximum likelihood
estimates of the coefficientsof this model together with some diagnostictests
are reported in Table 3. The table is divided vertically by portfolio and
horizontally by coefficient. Within each horizontal section the diagonal
elements are for the model without spillovers while the offdiagonal
elements are for the model with spillovers. Coefficient estimates above the
diagonals are when spillovers are from relatively small firm portfolios to
relatively large firm portfolios, while those below the diagonal are for the
reverse of this.
The following three considerations led to additional variables being
added to the conditional mean specification, equation (3). First, since the
sample period overlaps with the equity market crash of October 1987, a
dummy variable was included to cover that event. Second, as the U.K. stock
market has been observed to display a significant turn-of-the-year effect
(see Chelley-Steeley, 19961, a dummy variable was included for this feature.
Third, to ensure that volatility spillover relationships are not obscured by
the cross-serial correlations present in the returns series, see Table 2,
additional terms in the form of lagged returns on the other portfolios were
also included!
The coefficients b, measure the impact of past volatility surprises on
the current conditional volatility of the portfolio. There are clear patterns
related both to fum size and to the presence of spillover terms. First,the past
squared errors have more influence over the current conditional variance
of the portfolios of relatively small firms than they do over the conditional
variance of portfolios of relatively large h s . For example, the small firm
portfolio has bi coefficientvalues between 0.205 and 0.243, while the large
firm portfolio has b, coefficientvalues between 0.023 and 0.121. Second, the
impact of the past squared errors Of portfolio ion the conditional variance
of portfolio i is reduced in the presence of spillovers from podolioj.
The past conditional variance exerts a greater influence over the current
conditional variance in the case of the large firmportfolio than in the case of
the small firm portfolio, as measured by the estimated values of the coefficient
 90 The Manchester School

cf. Thus shocks to larger firm portfolios are more persistent than for smaller
firmportfolios. The relatively high persistence in the returns series of smaller
6rm portfolios is usually attributed to the relatively thin trading of small
company shares. By contrast, the relatively high persistence in the variance
process of larger firm portfolios cannot be attributed to the thin trading
phenomenon. The coefficient pairs, (b,,cf I &,), suggest that although
shocks to the volatility of large 6rm portfolios have less impact than shocks
to the volatility of smallfirm portfolios, they are much more persistent.'
We can obtain a clearer picture of the persistence in the volatility
processes by calculating the half-life of a shock to the process, that is, the
time that it takes for half of the shock to have dissipated. The half-life for
portfolio imay be calculated as

In the case of the small firm portfolio, the half-life is about 7 trading days
in length, whereas for the large firm portfolio, the half-life is about 20
trading days.6 Time series plots of the estimated conditional standard
deviations for each of the four portfolios appear in Fig. 1. These display the
value of &, using equations (1) and (2). They are qualitatively similar to
those for equations (3) and (4).
The coefficientskiJ measure the impact of past volatility surprises to
portfolio j , j # i, on the conditional variance of portfolio i. The estimates
of k, tend to be more statistically significant below the leading diagonal,
which is in cases where the volatility spillover is from a portfolio of rela-
tively large h s to a portfolio of relatively small firms. For example, the
past volatility of the large firm portfolio is important in determinin the
future volatility of the small firm portfolio, but the reverse is not so. We f
'NthoUgh the estimated coefficients are numerically distinct across portfolios, they may not
be Statistidy significantly different. In regressions based upon different samples of this
kind, Pesaran, Smith and Yeo (1985) recommended a test using the SUR methodology of
ZdnCr (1962). In the spirit of this procedure, we pooled portfolios on a pair-wise basis
and conducted analysis-of-variance tYpe tests. These relatively simple tests ruggested that
the portfolios were characterizedby statisticallydifferent coefficients.
half-lifeis calculated by finding E(h,,), using the result that E($) = h,, setting the growth
coefficientin the resulting differenceequation to 0.5. and solving for T.
'Since the variable e2,-l in the augmented GARCH equation, (4) is generated as the product
of another m d h , the estimated coefficientsmay not be unbiased or consistent. As a check
on the qualitative nature of the results, we used a multivariate GARCH model to capture
spillovers in two directions simultaneously. That is, we simultaneously estimated the
impact of past shocks to portfolio i on the conditional variance of portfolio j and the
impact of past shocks to portfoliof on the conditional va&trice of portfolio i. Our fin&@
wen supportive of the results from using the univariate model. In general, shocks to the
returns of relatively large firm portfolios spill over to the conditional variance of relatively
small firm portfolios, while the reverse does not appear to be the case. The procedure that
we followed b documented in Conrad erul. (1991).
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Volatility,Leverage and Firm Sue 91

can use the Ci coefficientsin combination with h~to determine the half-life
of a spillover volatility shock. Since the volatilities of larger firm portfolios
display more persistence, we would expect that the half-life of spillover
shocks from small firmportfolios to large h portfolios would be longer
t h a n those in the opposite direction. The calculated half-lives confinn this
picture with the half-lives being between 7 and 20 trading days for
spillover shocks from small firmportfolios to large firm portfolios and
between 3 and 7 days for spillover shocks from large h portfolios to
small portfolios.
The estimated j?, coefficientson the GARCH-M terms also display
an interesting pattern. The coefficientsare larger and have a greater statis-
tical significance in portfolios of smaller finns. This implies that the
smaller are the firms in a portfolio the more valuable is information
c o n e r n i a g the current value of the volatility. This feature is entirely
consistent with the previous results concerning the relative persistence of
volatility. Information on current volatility is most important for port-
folios of small firms exactly because it has a big impact and then decays
quickly. This feature, in combination with the spillover results, means that
the volatility shocks to the large firm portfolio are important in deter-
mining both the volatility and the mean return of the small firm portfolio.
me reverse is not the case.
To investigate further the relative importance of the conditional
variance in explaining the mean return of the portfolios, we have calculated
the marginal contributions made by the GARCH-M term (the conditional
volatility), the autoregressive term, and the cross-autoregressive terms to
the explanation of the mean returns for each portfolio.8 The results of this
likelihood-based calculation are shown in Fig. 2, where we have scaled the
heights of the bars relative to the contribution of the autoregressiveterm in
the small firm portfolio. It Can be seen that both the own and cross-
autoregressive terms contribute more than the GARCH-M terms for all of
the portfolios. To obtain some intuition regarding these magnitudes, we
calculated pseudo-R2s for the mean equations by estimating them alone,
using the previously generated conditional volatility series as the
GARCH-M regressor. These numbers are also reported in Fig. 2. The
relative contributions to these pseudo-R2sof the three variables of interest
were in agreement with the likelihood-based comparisons and were as
follows. The autoregressive terms were contributing between 4 and 6
percentage points, while the GARCH-M terms were contributing 1
percentage point or less to the overall pseudo-R2sfor the mean equations,
Although, for reasons explained earlier, these results should not be
interpreted in terms of an equilibrium risk-return relationship, it is
 92 The Manchester School

interesting nevertheless that the time series behaviow of the risk of

relatively well-diversified portfolios seems to contribute little to explaining
the time series behaviour of the returns of those portfolios.
The dummy variable for the crash was statistically significant for each
portfolio, while the turn-of-the-year dummy variable was significant for d l
portfolios except the one containing the largest firms.As a specification test
of the model, in equations (3) and (4), we calculated the sixth-order Ljung-
Box (1978) statistic for the standardized residuals of each of the four
portfolio expected return series and, in all but one case, the specification
appeared a d e q ~ a t e . ~

The Asymmetric Volatility Model

Table 4 contains maximum likelihood estimates of the coefficients of the
model in equations (5) and (6). The specification of the conditional mean is
the same as in equation (1) and includes dummy variables for the turn of the
year and the stock market crash, the lagged returns of other portfolios,
and the GARCH-M term, in the underlying ARMA(1,l) structure. The
magnitudes, signs and significanceof the estimated coefficients that feature
in both the symmetric and asymmetric conditional variance specifications,
Tables 3 and 4 respectively, are similar. Furthermore, the estimated coefi-
cicnts on the indicator term in the asymmetric specification are statistically
significant and contain interesting results regarding the leverage effect.In all
but portfolio 2, there appears to be evidence of a leverage effect in the
Portfolio returns series, that is, large negative returns have more impact on
volatility than large positive returns. The evidence is most strong for the
small firmportfolio. It also appears that this effect is stronger in the smaller
firm portfolio than in the larger tirm portfolio.'o
Spillover volatility shocks can also be decomposed into the impact of
the magnitude and the sign of the shock, by augmenting equation (6) in the
same manner as with equation (4). The results from this exercisewere mixed
and are not reported here. There appeared to be little evidence that the Sign
of the past return to one portfolio has any additional influence over the
future volatility of another portfolio. Other leverage specificationsproduced
similar results in general, with some weak evidence to suggest that the sign
of shocks to the large firm portfolio may on occasion be an important
determinant of the future volatility of the other portfolios. Multivariate
specificationsof the leverage model confirmedthese results.

'It dmdd be noted that the slight CXECSS kurtosis in the residuals, around 4 rather than the
nOmd benchmark of 3, will have lome impact on the reliability of the test statistics
reported in Tables 3 and 4.
'%a relationship to firm size appean to be sensitive to the specification of the particular
Ievenge model. All specifications, however, indicatethe presence of a leverage effect hthe
capitalization-rankedportfolio returns.
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,
 Volatility, Leverage and Firm Size 93
It is possible that the asymmetric specification of the volatility has a
different relative contribution to explaining mean returns than was the case
with the spillover model. Fig. 3 shows a repeat of the procedure that was
conducted for the spillover model to compare the relative marginal
contributions of the GARCH-M term, the autoregressive term, and the
cross-autoregressive terms to the explanation of the mean returns for each
portfolio for the leverage model. Once more, the own and cross-
autoregressive terms contribute more than the GARCH-M terms for all of
the portfolios. The results from calculating pseudo-R's for the mean
equation were in broad agreement, except for the contribution of the
GARCH-M term in the small firm portfolio, whose contribution to the
pseudo-R2 was significantly overstated relative to the likelihood
comparison. Other than this, the results were also numerically similar to
those for the volatility spillover model where the autoregressive terms were
contributing up to 6 percentage points and the GARCH-M terms were
contributing 1 percentage point or less to the overall pseudo-R2s for the
mean equations.
In terms of diagnostic tests on the residuals, both the volatility
spillover model and the leverage model appear to be reasonably well
specified. In terms of a comparison of likelihood statistics, however, the
following ranking occurs. The spillover model, when volatility spillovers
are from relatively large to relatively small firm portfolios, has the highest
likelihood values. The leverage model produces the next highest set of
likelihood statistics, which are greater than those of the symmetric model
without spillovers, equations (1) and (21, except in the case of the large firm
portfolio. Finally, spillovers from relatively small firm portfolios to
relatively large firm portfolios do not appear to add anything to a model
without spillovers.
When all the models were re-estimated for sub-samples, the general
pattern of results was maintained. The returns of large firm portfolios
tended to predict the returns of small firm portfolios. The volatility shocks
of relatively large firmPOrtfOliOSwere important factors in the volatility and
expected returns of relatively small firmportfolios. The leverage effectwas
present and there was Some weak evidence ofspillover effects from relatively
large to relatively small firm portfolios. However, later years within the
sample period did indicate an increased persistence in the variance processes
of all of the portfolios.

v DISCUSSION
AND CONCLUSIONS

In this study of U.K. stock market volatility, our aim has &en to
characterize the transmission of volatility between and within capitalization-
ranked portfolios. We chose to work with capitalization-based portfolios
for two reasons. First, we could examine the impact that firm size has On the
~ ~ ~ I ~ ~ L t d d ~ V 1996.~ I J d ~ ~ d M ~ ,
 94 The Manchester School

characteristics of volatility in the U.K.stock market. Second, we did not

need to use published indices, which may be constructed and rebalanced
differently and have overlapping size profiles.
Examining the raw returns series, we found distinct differences between
the portfolios. Returns to relatively small firm portfolios were found to be
more autocorrelated and more leptokurtic. These results are consistent with
the relatively infrequent trading of smaller firm shares. We also found an
asymmetry in the cross-autocorrelations of the returns series. We found
that, while small firm returns could not predict future large firm returns,
large firm returns appeared to be able to predict future small firm returns.
The autocorrelation structure appeared at several lag spacings, being most
significant for shorter horizons.
We found evidence of strong autocorrelation among the squared and
absolute returns of the portfolio. This suggested that the returns series could
possess a time-varying conditional variance process. We modelled the
combined mean and variance process for each portfolio using an
ARMA(1,I)-GARCH( 1,l)-M time series specification. The ARMA(I.1)
process captured the autocorrelation structure of the portfolio returns
series, while the GARCH(1,l) conditional volatility process captured the
persistence and clustering of the squared residuals from the conditional
mean process. The GARCH-M term allowed the volatility to directly
influencethe conditional mean. This term was found to be significant in all
but the large firm portfolio. Our results suggest that shocks to the volatility
of relatively large firm portfolios are more persistent than those to the
volatility of small firm portfolios. In contrast, the initial impact of a shock
to the volatility of the small firm portfolio is much greater. While this latter
differencecould be ascribed to the impact of information catch-up as small
firms tend to trade less frequently, the relative persistence of shocks to large
firms must come from a different source. One possibility is that it could be
a result of the mechanical rules that are often in place to trade large firm
shares,
We compared two extensions of this underlying model: first, a model
where shocks from one portfolio were allowed to enter the conditional
variance equation of another portfolio and, second, where the sign of the
hocks was separated out from the magnitude of the shocks. We found that
shocks to the volatility of portfolios of relatively large firms were important
in determining the future volatility of portfolios of relatively small firms.
The reverse, however, did not appear to be the case. Using the second model,
we found some evidence that the sign of returns was important in de-
termining the future volatility of portfolio returns and that, in general, the
relationshipwas a negative one.
In conclusion, our results suggest that the volatility of the returns of
large firm shares in the U.K.,and by implication the volatility of value-
weighted market indexes, appear to be characterized by a symmetric model
0 B l r k w d l Publlrhn Ltd and Thr Vtctorli Unlmnity d M.ar&W, 1996
Volatility, Leverage and Firm Size 95

without spillover terms. The volatility of smaller firm portfolios demon-

strates a dependence on the volatility of relatively larger firm portfolios
and on the sign of its own unexpected returns. This dependence increases
as firm size decreases. Furthermore, by including a GARCH-M term, we
were able to identify the impact that the volatility process has on the mean
return of each portfolio. Since volatility is relatively more important for
smaller firm portfolio returns, understanding the spillover and leverage
characteristics of the volatility process of these portfolio returns becomes
even more important.
.c
8 SOo.0- S10-0- C9OQ- 6010 LLOQ 0109 O!XkO 8P1Q SIIQ Em0 960-0 ooO.1 6L8Q ?69Q 662-0 ?I
ZOLQ '*'bl
3
k
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201.0
pZ1.0

ZSOQ
SSI.0
081.0

120-0
9EI.0
561.0

810-0
011-0
5PI-0
8610
ZVZ.0
6PZQ
?91Q
SZI.0
W.0

Zl1-0 WIQ
91Z-0 ZPZO
991.0 852-0

PZE.0
96f9
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86Z-O
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86EQ

64.0
98fQ
SOP0

6ff-0
9SE.0
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6L80
P690
6690

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C-fQ c-rf~ f-fzv c-nbl z-1.~ z-rrbl wtbl z - a M wzbl L-IX~ r- I X ~ ria
OIE.69 8609 LSOQ tZlQ S f0.0 MIQ 6ZE.91
081.1121 opo-0 Of00 901-0 L90-0 2OE-o l*Sl
OPZQZZ ESOQ 260-0 SIIQ (919 6LtQ 61E-ZI
OLS.661 LUH) 6900 0601) 9?1Q PPEQ PZ6-01
OS9Z91 9HI-O m-0 6pO-0 ?loo 8zM) E69-I
WLWI mo u)M) SO-0 250.0 6LEQ C%1
0LS.SPZ If09 *LOO 9so-o 2I1.0 S9p-o 6980
OtI-LZV stroo ZSOO Z909 WIQ w90 ZSLQ
OSC-L 180-1- E@EE POQO 6f00- 6SOQ IzO-0- WIQ 59L-€2
UE-9 IS6.0- 90601 9EW 9100- 560-0 LSM) 86ZQ LWZZ
61)-8 IE69- S6.861 9SOQ 8SO-O LZIQ %lQ 98tQ 298.91
9Z9-01 6pt.1- WZPZ 5600 EI-0 811-0 S?10 [OM) 988-PI
rzrotrny- a 'e Y 'd
vo&rilify, Leverage andFirm Size 97
3
TABLE
ARMA( 1, 1)-OARCH(1, 1)-M MODELSFOR PORTPOLIO RETURNS p u ~ w ~
VOLATILITY SPILLOVERS
mble contains the C S h a t e s Ofthe p a k w hVOk+tiiitYSflOVCr effectsusing the model
A

6.513 (2.777) 6.286 (2.357) 5.259 (2-597) 3.126 (1.58S)

6.390 (2.651) 6244 (2.436) 5.374 (2.602) 3.322 (1.720)
6.069 (2455) 6.072 (2.355) 5.303 (2.630) 3.358 (1.694)
6-301 (2.992) 6.286 (2.494) 5.066 (2.456) 3,199 (1.674)
0.243 (5460) 0.203 (4.461) 0.214 (4.225) 0.114 (3.566)
0.221 (3.914) 0.249 (5.265) 0.213 (4.012) 0.119 (3.551)
0.205 (3.766) 0.310 (3.456) 0.215 (4.399) 0.023 (0.789)
0.219 (3.718) 0.169 (3.999) 0.163 (2.769) 0.121 (4.021)
0-356 (4-202) 0539 (6.081) 0-592 (8143) 0.731 (11.946)
0.332 (3.704) 0.512 (5.855) 0.588 (8.049) 0.699 (10.478)
0.293 (3.302) 0.575 (8.685) 0.597 (8-272) 0.688 (10-108)
0.261 (2.796) 0.538 (6.841) 0.590 (8.016) 0.730 (12.373)
0.062 (1.979) 0.011 (0.223) 0.020 (0.392)
0.031 (1.299) 0.013 (0-282) 0-038 (0407)
0.043 (2609) Oa9 (3.382) 0.152 (3435)
0.034 (2.550) 0-041 (2.840) 0.048 (1.488)
-0.101 (4.679) -0.1 17 (4.454) -0.310 {4.332] -0.337 {3463)
-0.112 {4431) -0.080 (4.465) -0,306 (4.332) -0.297 (3.678)
-0.112 (4.989) -0.361 {4-706) -0.306 (4-314) -0.383 (4.198)
-0493 (4169) 0527 {3*219) -0.301 (4-362) -0.297 (3.650)
7.612 (0.2681 3.314 (0.7691 7.711 [0260] 6.738 (0.3461
8.250 (0-2201 3.216 [0,781] 7.755 [0-256] 7.349 f0.2901
7333 [0.247] 8.988 [0*174] 7.697 10.2611 7.182 [0.304]
7.553 [0273] 20532 [0.002] 7.534 I02741 6.855 Io.3351
3271 3156 2886 2776
3271 3153 2886 2777
3275 3159 2886 2776
3277 3158 2887 2776

0-4 PublishanLtd and The Victoria University of M . o c h m . 1996.

0
\o
c m

4
TABLE
f ASC
- CONDYTIONAL VARIANCE MODBLS
FOR PORTpoLlO RETURNS
This table contains the estimated coefficientsfrom the model
2 4
&.t = k + d&t-i + B,kt+ XY~JR~J-I
+ 4,iDi.t + di.z&.t +qt - &%,+1 iJ = 1,2.3,4 where Ia-1 N(0, kl)
-
t-1
5E izi
kt = 4 + bi&i + C i 4 t - i + W , t - l 4 t - i
!' where R,,l are the weekly returns on the four portfolios. All the estimated parameters are denoted by a caret,and the n u m k s in parentheses below the
estimated coefficients are t-statistics. Skewness and kurtosis figures are for the s t a n d a r M residuals of the model. The Q-statistics are the Ljung-Box
statistics testing the hypothesis that all autocorrelations in the standardized residuals up to lag 6 are jointly zero. Their pvalues are given in brackets
alongside each cdiicient.
'[
7
6
a Portfolio LfJgL jix I d a D j? fix1o4 ixid 2 i x 10' Skewness Kurtosis Q
W
c
1 3273 1.265 0.753 0-674 2.371 0.687 0.126 0.280 0-420 0445 4.971 7.720
(0-463) (14-876) (11.653) (1.787) (6.228) (2487) (2.849) (3.859) [0.259]
2 3155 -1-185 0.491 0-480 9.702 0.528 0.311 0.503 -0.136 -0.157 4448 2.506
(-1.973) (6-028) (5.171) (3.006) (4.577) (4.954) (6.272) (-2.161) [0.868] tq
3 2887 -0.625 0.555 0.583 3993 0.760 0.168 0-592 0.142 -0.196 4.221 8.213 5
(-0-948) (7-131) (7.810) (2.343) (4.592) (3-079) (8.341) (2.558) [0.223]
4 2772 -0.239 0.830 0.685 1.789 0.735 0-090 0.725 0-070 -0-380 4467 6.603
(-0.282) (7.680) (6-559) (1.01 1) (3.928) (2.786) (12.425) (1.566) [0*359]
ss
Volatility,Leverage and Firm Size 99
Panel (a): Small Firm Portfolio

0.2

Panel 0):
Small-Intermediate Firm Portfolio
0.4

0.3

02

0.1

FIQ. 1 Conditional Standard Deviations of Portfolio Returns

 100 The Manchester School

Panel (c): Intermediate-Large Firm Portfolio

oVol/n 03101179 31/IZ/M) 29/12/82 26/12/64 24/12/86 21/12/88 19/12/90

Panel (d): Large Firm Portfolio

-

0 1 . " . ' " ' . ' . ' " " A

MIOI/T6 0110117l 02/01/10 M/12/81 28112l83 25/12/85 23/12/87 .ZO/IZ/W 18/12/91
05/01/77 03/01/79 31/12/80 29/12/82 26/12/64 24/12/86 21/12/88 19/12/90

FIO.1 Conditional Standard Deviations of PortfolioReturns

0 Blackwoll Pvbliihcn Ltd and Ths Victona University of Manchcster, 1996.
Volatility, Leverage and Firm Size 101

I'2 I

04

:O0.2
'0

ponfoho I (27%) Portfoh~2 (24%) Portfolro 3 (16%) Portfolio 4 (8%)

aGARCH-M CroM-AR( I )

FIG. 2 Marginal Contributions to Mean Returns (Symmetric Variance)

Marginal contributions measured relative? the AR(1) variable for the small firm portfolio.
mefigures in parentheses are pseudo-R s for the mean return equation for that portfolio.
1.2

0.8

0.6

04

02

0
 102 The Manchester School
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