Modeling the Conditional Covariance between Stock and Bond Returns: A Multivariate GARCH Approach

45 Pages Posted: 16 Mar 2002

See all articles by Wessel Marquering

Wessel Marquering

Erasmus University Rotterdam (EUR) - Department of Financial Management

Peter de Goeij

Tilburg University

Multiple version iconThere are 2 versions of this paper

Date Written: January 17, 2002

Abstract

To analyze the intertemporal interaction between the stock and bond market returns, we allow the conditional covariance matrix to vary over time according to a multivariate GARCH model similar to Bollerslev, Engle and Wooldridge (1988). We extend the model such that it allows for asymmetric effects on conditional variances and covariances. Using weekly U.S. stock and bond market data, we find strong evidence of conditional heteroskedasticity in the covariance between stock and bond market returns. The results indicate that not only variances, but also covariances respond asymmetrically to return shocks. Regardless of the bond market shocks, bad news in the stock market is typically followed by a higher conditional covariance than good news. We find that volatility timing strategies for dynamic asset allocation significantly outperform passive strategies. Even when short-sale restrictions are present and transaction costs are high, the economic value of dynamic trading strategies is larger than that of a passive strategy. Moreover, the symmetric volatility timing strategy is outperformed by its asymmetric counterpart.

Keywords: Multivariate GARCH, stock and bond market interaction, time-varying volatility, asymmetric effects, impact of news

JEL Classification: M, G3, G11, G12, C22

Suggested Citation

Marquering, Wessel A. and de Goeij, Peter, Modeling the Conditional Covariance between Stock and Bond Returns: A Multivariate GARCH Approach (January 17, 2002). ERIM Report Series No. ERS-2002-11-F&A; EFA 2002 Berlin Meetings Discussion Paper; EFMA 2002 London Meetings. Available at SSRN: https://ssrn.com/abstract=302335 or http://dx.doi.org/10.2139/ssrn.302335

Wessel A. Marquering (Contact Author)

Erasmus University Rotterdam (EUR) - Department of Financial Management ( email )

P.O. Box 1738
F4-26
Rotterdam 3000 DR
Netherlands
+31 10 408 2786 (Phone)
+31 10 408 9017 (Fax)

Peter De Goeij

Tilburg University ( email )

P.O. Box 90153
Room I607
Tilburg, Noord-Brabant 5000 LE
Netherlands
+31134662083 (Phone)

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