Contemporaneous and Dynamic Relationships Between Volatility, Returns and Trading Volume
School of Economics, Business Administration and Legal Studies, MSc in Banking and Finance
This dissertation was written as a part of the Msc in Banking and Finance at the International Hellenic University. This study refers mainly in financial analysts, risk managers and equity researchers that try to select the best undervalued stocks for their portfolio and I explain if trading volume can really be taken into consideration as a financial tool thatanalysts can use to predict price changes and future volatility.
In this study, the relationship between Index returns of twelve stock exchanges and its corresponding aggregate trading volume is examined. Many volatility measures were used to research for possible contemporaneous and dynamic relationships between volatility, returns and trading volume. The main goal of the study was to prove whether information about trading volume can improve the predictability of future returns.
Empirical results suggest a strong contemporaneous positive relationship between volatility and trading volume and an average positive relationship between trading volume and returns if GARCH models are used. GARCH models are sufficient to remove GARCH effects to the majority of the sample and the inclusion of trading volume in the conditional variance does not attain to eliminate all GARCH effects but manage to decrease average sample volatility persistence but not to the degree Lamoureaux and Lastrapes suggested. T-GARCH also used in order to take into consideration the leverage effect of volatility which was present to the majority of countries. However, the extension of GARCH model failed to provide further explanation or better results as regards to the decrease of volatility persistence and elimination of GARCH effects. As regards the dynamic relationship in the majority of the sample strong relationship between volatility and trading volume is verified by either measure but by using conditional variance, volume granger causes the volatility while the vice versa happens with the rest volatility measures (R2 and |R_t|). Returns-volume causality is not so clear and vary from country to country. This can also be explained from different characteristics among different stock exchanges around the world or even calendar effects. Despite the strong contemporaneous relationship between trading volume and index returns in most of the countries, we can’t say confidently that these relationships hold dynamically.