An Economic Covariance Model of Stock-Bond Dynamics
29 Pages Posted: 23 Jun 2018
Date Written: May 24, 2018
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: Suggested Citation