easy · FRM Part 2 Market Risk
The 'leverage effect' is often cited as a structural reason for the equity skew.
According to this theory, why does volatility tend to rise as stock prices fall?
- Market makers increase bid-ask spreads at lower prices, which is misinterpreted as higher implied volatility.
- As the equity value falls, the firm's debt-to-equity ratio increases, making the remaining equity riskier.
- Companies with falling stock prices are more likely to pay higher dividends to retain shareholders.
- Lower stock prices attract more retail investors, increasing the daily trading volume and volatility.
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