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Crisis “shock factors” and the cross-section of global equity returns

Autumn 2008 was calamitous for global equities. This column presents data on stock returns from over 17,000 firms in 44 countries suggesting that the decline in share prices was associated with three separate and identifiable “shock factors”: the fall in global demand, the contraction of credit supply, and the selling pressure on equity as investors were forced to unload some of their holdings.

The financial crisis of 2007-2008 was a significant shock to the financial system and the global economy. The shock that originated in the mortgage market and banking system reduced the supply of credit, led to distressed sales of risky assets as banks and investors scrambled to shore up their liquidity and capital ratios, and plunged the global economy into a severe recession, one in which economic activity either slowed or contracted (IMF 2009), and global trade collapsed (Baldwin 2009). While the crisis originated in the US and other developed economies, it quickly spread over the globe, affecting all economies, which saw their stock prices collapse as investors panicked.

Learning from stock returns

Stock returns are a unique measure of performance. It is comparable across firms and countries, forward-looking, comprehensive in scope, and insensitive to differences in accounting rules. In normal times, a firm’s stock returns reflect a combination of expected returns (its loadings on risk factors) and “residual returns” that are associated with firm-specific news. At times of significant economy-wide shocks, however, the cross-section of residual returns can be understood as reflecting the differing exposure of firms to unexpected shocks.

In a recent paper (Calomiris et al. 2010), we consider whether the financial crisis of 2007-2008 was a unique event from the standpoint of stock returns and isolate crisis-related “shock factors” that can explain the cross-section of residual returns during the crisis. In particular, we argue that three categories of crisis-related shocks contributed to the decline of equity prices worldwide during the financial crisis of 2007-2008:

  • reduced global product demand,
  • contraction in the supply of credit, and
  • selling pressure in the equity markets.

We use data on over 17,000 firms in 44 countries around the world to study whether cross-sectional stock returns over the period of August 2007 to December 2008 can be explained by the crisis “shock factors” described above.

Empirically, we use values from 2006 to construct our shock factors, which are based on firm characteristics observed prior to the crisis. We then compare our results for the crisis period with a similarly structured model of the “placebo” period (that runs from August 2005 to December 2006 and uses predetermined values from 2004 to construct shock factors).

We measure global demand shock sensitivity using firm-specific variables that capture the exposure of a firm to global trade. Our two measures are the firm’s pre-crisis proportion of sales outside the company’s home country and the proportion of company assets held outside the company’s home country. We find that firms with higher foreign sales or foreign assets exhibit significantly more negative returns, controlling for other factors.

We measure the sensitivity of a firm’s equity to selling pressures in the stock market using two variables: pre-crisis free float relative to the total market value of equity, and pre-crisis stock turnover (the volume of trading relative to outstanding market value of equity). These measures are intended to capture the relative liquidity of a stock prior to the crisis.

In theory, the effect of stock liquidity on returns is ambiguous. On the one hand, greater liquidity may be associated with steeper declines in equity prices, as investors select their most liquid risky assets to sell during a liquidity squeeze. On the other hand, liquidity becomes more valuable during a crisis, implying that relatively illiquid stocks may experience relative price declines. Our findings indicate that during the recent crisis the former effect was dominant.

Vulnerability to credit-supply shocks should reflect both the exogenous external finance costs of the firm and its endogenous financial choices. To capture both sorts of contributors to financial fragility, we considered a variety of measures that had been identified in the literature, and settled on a subset of indicators that capture endogenous leverage choices as well as exogenous characteristics related to external financing costs.

We chose four indicators to capture the sensitivity of firms to the credit-supply shock aspect of the crisis:

  • the ratio of dividends to sales (where a low value indicates a high cost of external finance),
  • leverage (total debt to assets),
  • a dummy variable that is a threshold measure of potential financial distress, which distinguishes whether firms’ debt service payments are very high relative to their earnings – firms that have debt service coverage greater than one are defined as “good coverage” firms, and
  • an interaction effect that considers the effect of leverage interacted with good coverage.

The four corporate finance indicators used to measure the sensitivity to credit supply shocks enter with the predicted signs and are statistically significant. Dividends-to-sales enters positively, indicating that firms with higher pre-crisis payout tended to experience higher residual returns during the crisis. Leverage enters negatively, good coverage enters positively, and the interaction between the two also enters negatively and significantly.

Our results are robust to three ways of modelling the influence of “shock factors”:

  • as three sets of individual variables that enter separately as regressors in the model of residual returns,
  • as the first principal component of the set of individual regressors used to measure each category of influence, and
  • as dummy variables that divide firms in groups of those with high, medium, and low combined values of shock-factor variables within each of the three categories, based on combinations of regressor values.

A month-by-month analysis of the importance of shock factors during the crisis period shows that the time variation of the importance of each of the “shock factors” tracks related changes in the global economic environment. The magnitude of the negative coefficients associated with the global demand shock factor rises during times of greatest decline in exports (see Figure 1). The variation over time in the coefficients that measure the stock market selling pressure shock factor closely tracks the variation in the returns to the stock market (see Figure 2). Time variation in the coefficients associated with the credit-supply factor are similar to those found in credit-risk spreads that reflect the timing of credit-supply shocks (see Figure 3).

Figure 1.

Figure 2.

Figure 3. 


We conclude that the financial crisis was associated with three separate and identifiable types of unique influences on firms’ equity returns – the decline in global demand, the contraction of credit supply, and selling pressure on equity as some investors were forced to unload some of their holdings.

These three “shock factors” can be identified using the characteristics of firms to gauge their exposure to each factor. The importance of each factor varies across firms and across time (within the crisis period) in ways that we would expect.


Baldwin, Richard (ed.) (2009), The Great Trade Collapse: Causes, Consequence and Prospects, A VoxEU.org Publication, 27 November.

Calomiris, Charles W., Inessa Love, and María S. Martínez Pería. “Crisis ‘Shock Factors’ and the Cross-Section of Global Equity Returns,”. NBER Working Paper 16559. November, 2010.

IMF (2009), World Economic Outlook: Crisis and Recovery, April 2009.


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