An Economic Covariance Model of Stock-Bond Dynamics

29 Pages Posted: 23 Jun 2018

See all articles by Fahad Saleh

Fahad Saleh

McGill University - Desautels Faculty of Management

Date Written: May 24, 2018

Abstract

The price of equity equals the risk-adjusted present discounted value of cash-flows. Discount factors depend upon the short rate process. As such, a link exists between bond and equity returns. This link implies a relationship between volatilities and the stock-bond correlation. I show that the stock-bond correlation increases in interest rate volatility and decreases in cash-flow volatility. These results qualitatively explain the historical variation in the stock-bond correlation including the mysterious sign change around the turn of the century. I take the aforementioned insights and marry them with the multivariate volatility modeling literature to produce an economic covariance model of stock-bond dynamics. The resulting model possesses the empirical quality of an econometric model and the economic content of an asset pricing model. This empirical model outperforms a GJR-DCC model. I provide both in-sample and out-of-sample results. I also show that the results hold for individual stocks.

Keywords: Bonds, Correlations, DCC, Equity, Fixed Income, Stocks, Volatility

JEL Classification: C58, G11, G12, G17

Suggested Citation

Saleh, Fahad, An Economic Covariance Model of Stock-Bond Dynamics (May 24, 2018). Available at SSRN: https://ssrn.com/abstract=3193486 or http://dx.doi.org/10.2139/ssrn.3193486

Fahad Saleh (Contact Author)

McGill University - Desautels Faculty of Management ( email )

1001 Sherbrooke St. West
Montreal, Quebec H3A1G5 H3A 2M1
Canada

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