Correlations between Stock Returns and Bond Returns: Income and Substitution Effects

41 Pages Posted: 23 Aug 2010

See all articles by Bong-Soo Lee

Bong-Soo Lee

Florida State University

Gwangheon Hong

Sogang University

Youngsoo Kim

University of Regina - Faculty of Business Administration

Date Written: December 20, 2009

Abstract

We attempt to better understand varying correlations between stock and bond returns across countries and over sample periods using international data. The observation is that there are two forces that affect the correlation between stock and bond returns. The force that drives a positive correlation is identified as the income effect. The force that drives a negative correlation is identified as the substitution effect. In combination, the two effects help determine the actual correlation between stock and bond returns. We contribute to the literature by proposing an empirical method, structural vector autoregression (VAR) identification method, to identify the two – income and substitution – effects and to measure the relative importance of the two effects that determine the actual net relation between the two asset returns. We further provide some evidence that the income and substitution effects are related to, among other things, the size of the financial market, the growth and volatility (risk) of the economy, and the business cycle over time. In addition, the framework of the income and substitution effects helps us better understand the automatic stabilizing effects of the dynamic optimal asset allocation during business cycles.

Suggested Citation

Lee, Bong-Soo and Hong, Gwangheon and Kim, Youngsoo, Correlations between Stock Returns and Bond Returns: Income and Substitution Effects (December 20, 2009). Available at SSRN: https://ssrn.com/abstract=1662737 or http://dx.doi.org/10.2139/ssrn.1662737

Bong-Soo Lee

Florida State University ( email )

423 Rovetta Business Building
Tallahassee, FL 32306-1110
United States
850-644-4713 (Phone)

HOME PAGE: http://www.cob.fsu.edu/fin/display_faculty_info.cfm?pID=401

Gwangheon Hong

Sogang University ( email )

35 Baekbeom-ro
Seoul, 121-742
Korea

Youngsoo Kim (Contact Author)

University of Regina - Faculty of Business Administration ( email )

Canada