The Empirical Relationship between Trading Volume, Returns and Volatility

This paper presents an empirical analysis of the relationship between trading volume and stock return volatility in the Australian market. The initial analysis centres upon Karpoff's [1986, 1987] model of the volume-price change relationship. Evidence is found which supports the model. The relationship between price change and trading volume, irrespective of the direction of the price change, is significant across three alternative measures of daily trading volume for the aggregate market and individual stocks. Furthermore, evidence is found supporting the hypothesis that the volume-price change slope for negative returns is smaller than the slope for positive returns, thereby supporting an asymmetric relationship. Trading volume is then examined in the context of conditional volatility using a GARCH framework. Similar to the results of Lamoureux and Lastrapes [1990], the findings show a reduction in the significance and magnitude of the conditional variance equation coefficients, and a reduction in the persistence of variance when trading volume is added as an exogenous variable. Hence, there is prima facie evidence that if trading volume proxies for the rate of information arrival, then ARCH effects and much of the persistence in variance can be explained. Acknowledgments: This paper has benefited from the comments of Rob Brown, Robert Faff, Keith McLaren, workshop participants at the University of Southern Queensland and delegates at the AsiaPacific Finance Association Conference (Sydney, 1994). The financial assistance of a Faculty Research Grant at the University of Melbourne is gratefully acknowledged. Contact: Tim Brailsford, Department of Accounting and Finance, University of Melbourne, Parkville 3052. Australia. Phone: +61-3-344-7662 FAX: +61-3-344-6681 Email: [email protected] 2