Pricing Equity-Bond Covariance Risk: Between Flight-to-Quality and Fear-of-Missing-Out

Posted: 23 Nov 2020

Date Written: August 28, 2020

Abstract

Motivated by Merton (1973), we propose a novel bivariate intertemporal asset pricing model, which relates expected equity and bond market returns to their conditional covariance. Investors' dynamic hedging demand coincides with covariance risk, which in turn plays a central role in explaining contemporaneous time-variation in expected market returns. Our model predictions are consistent with variations in expected equity and bond returns that include flight-to-quality and fear-of-missing-out episodes, both of which coincide with low levels of equity-bond covariance. We identify determinants of time-variation in conditional covariance and thus potential drivers of flight-to-quality and fear-of-missing-out. Unanticipated changes in expected inflation, market illiquidity and stock market uncertainty predict changes in the equity-bond covariance, where the contribution of each variable is state-dependent. In particular, the non-linear effects of shocks to inflation act as a key driver.

Keywords: Covariance Risk, Dynamic Hedging, Equity Premium, Fear-of-Missing-Out (FOMO), Flight-to-Quality (FTQ)

JEL Classification: C58, E44, G12

Suggested Citation

Perras, Patrizia J. and Wagner, Niklas F., Pricing Equity-Bond Covariance Risk: Between Flight-to-Quality and Fear-of-Missing-Out (August 28, 2020). Journal of Economic Dynamics and Control, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3705240

Patrizia J. Perras

Passau University ( email )

Niklas F. Wagner (Contact Author)

Passau University ( email )

Innstrasse 27
Passau, 94030
Germany

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