1 Spillover and Asymmetric-volatility Effects of Leveraged and Inverse Leveraged Exchange Traded Funds Jo-Hui Chen* John Francis Diaz** Abstract This paper employs the Exponential General Autoregressive Conditional Heteroskedasticity-in-Mean-Autoregressive Moving Average (EGARCH- M-ARMA) model to study the spillover of returns and volatilities of leveraged exchange-traded funds (ETFs). It is found that there is strong positive (negative) influence of lagged leveraged (inverse leveraged) ETF returns on current stock index returns. Lagged stock index returns have a negative (positive) effect on leveraged (inverse leveraged) ETF returns as a result of adding (reducing) exposures of total return swaps. A negative bilateral relationship is evident in the spillover effects of returns, and a bilateral relationship of spillover effects of volatilities is also observed from the results. The findings provide evidence regarding the higher volatility caused by leveraged ETFs. The relationship between risks and returns is negative for both the stock index and inverse leveraged ETF returns, whereas, the positive relationship for leveraged ETFs has minor significance. Field of Research: Finance 1. Introduction Exchange-traded funds (ETFs) originally replicate the performances of stock indices, and they have extended into sectors, international markets, fixed income, bonds, commodities, and currency. 1 A broad selection of leveraged ETFs is available for every major market - equities, bonds, commodities, currencies, and real estate. This paper focuses on leveraged ETFs for the equities market comprising almost 69% ($19.3 billion out of $28.14 billion) of market capitalization in the leveraged ETF market, based on the 2009 Leverage Equities ETFdb Category Report. As of 18 December 2009, there are already 128 leveraged ETFs in existence, among which 91 are leveraged equities ETFs. 2 These ETFs are designed to double, triple, or produce another multiple of the returns of an underlying index or a financial benchmark daily; and this also includes the inverse of the returns. 3 This study covers five leveraged ETFs and five inverse leveraged ETFs with their stock because no formal empirical study has delved into the spillover and leverage effects of this *Dr. Jo-Hui Chen, Department of Finance, Chung Yuan Christian University, Chung-li City, Taiwan Email: johui@cycu.edu.tw ; **Mr. John Francis Diaz, Department of Finance, Chung Yuan Christian University, Chung-li City, Taiwan Email: g9704630@cycu.edu.tw