Asymmetric Dynamics in the Correlations of Global Equity and Bond Returns

Posted: 2 Apr 2008

See all articles by Lorenzo Cappiello

Lorenzo Cappiello

European Central Bank (ECB)

Robert F. Engle

New York University - Leonard N. Stern School of Business - Department of Economics; New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER)

Kevin Sheppard

University of Oxford - Department of Economics; University of Oxford - Oxford-Man Institute of Quantitative Finance

Multiple version iconThere are 2 versions of this paper

Date Written: 2006

Abstract

This paper proposes a new generalized autoregressive conditionally heteroskedastic (GARCH) process, the asymmetric generalized dynamic conditional correlation (AG-DCC) model. The AG-DCC process extends previous specifications along two dimensions: it allows for series-specific news impact and smoothing parameters and permits conditional asymmetries in correlation dynamics. The AG-DCC specification is well suited to examine correlation dynamics among different asset classes and investigate the presence of asymmetric responses in conditional variances and correlations to negative returns. We employ the AG-DCC model to analyze the behavior of international equities and government bonds. While equity returns show strong evidence of asymmetries in conditional volatility, little is found for bond returns. However, both equities and bonds exhibit asymmetries in conditional correlations, with equities responding stronger than bonds to joint bad news. The article also finds that, during periods of financial turmoil, equity market volatilities show important linkages, and conditional equity correlations among regional groups increase dramatically. Furthermore, in January 1999 with the introduction of the euro, we document significant evidence of a structural break in correlation although not in volatility. The introduction of a fixed exchange rate regime leads to near-perfect correlation among bond returns within the European Monetary Union (EMU) countries, which is not surprising when considering the harmonization in monetary policy. However, the increase in return correlation is not restricted to bond returns in EMU countries: equity return correlation both within and outside the EMU also increases.

Keywords: dynamic conditional correlation' international stock and bond correlation' multivariate GARCH' variance targeting

Suggested Citation

Cappiello, Lorenzo and Engle, Robert F. and Sheppard, Kevin Keith, Asymmetric Dynamics in the Correlations of Global Equity and Bond Returns ( 2006). Journal of Financial Econometrics, Vol. 4, Issue 4, pp. 537-572, 2006. Available at SSRN: https://ssrn.com/abstract=1115054 or http://dx.doi.org/10.1093/jjfinec/nbl005

Lorenzo Cappiello

European Central Bank (ECB) ( email )

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Robert F. Engle

New York University - Leonard N. Stern School of Business - Department of Economics ( email )

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New York University (NYU) - Department of Finance

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Kevin Keith Sheppard

University of Oxford - Department of Economics ( email )

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University of Oxford - Oxford-Man Institute of Quantitative Finance ( email )

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