the Dow changed by more than 1 percent in two out of every three trad-
ing days.
Most of the periods of high volatility occur when the market has
declined. The standard deviation of daily returns is about 25 percent
higher in recessions than in expansions. There are two reasons why
volatility increases in a recession. First, recessions are more unusual and
entail greater economic uncertainty than expansions. The second is that,
if earnings fall sharply, then the burden of fixed costs becomes higher
and the volatility of profits greater. This leads to increased volatility in
the equity value of firms.
If earnings turn into losses, then the equity value of the firms acts
like an out-of-the-money option that pays off only if the firm eventually
does well to cover its costs. Otherwise, it is worthless. It is not a puzzle
why stock volatility was the greatest during the Great Depression when,CHAPTER 16 Market Volatility 279
FIGURE 16–2
Annual Volatility of Stock Returns (Annualized Standard Deviation of Monthly Returns), 1834 through
December 2006