Dynamics of Bond and Stock Returns
69 Pages Posted: 18 Apr 2015 Last revised: 17 Dec 2021
Date Written: December 15, 2021
A production-based equilibrium model jointly prices bond and stock returns and produces time-varying correlation between stock and real treasury returns that changes in both magnitude and sign. The term premium is time-varying and changes sign. The model incorporates time-varying risk aversion and two physical technologies with different cash-flow risks. Bonds hedge risk-aversion shocks and command negative term premium through this channel. Cash-flow shocks produce co-movement of bond and stock returns and positive term premium. Relative strength of these two mechanisms varies over time. The correlation is a powerful predictor of relative bond-stock and long-short equity returns in the data.
Keywords: bond-stock correlation, risk premia, general equilibrium
JEL Classification: G11, G12, E21, E23
Suggested Citation: Suggested Citation