The Price of Bond Market-Stock Market Correlation Risk

Abstract

Bonds are attractive investment instruments that complement a broad-based equity portfolio. As the correlation between stocks and bonds increases, investors lose diversification benefits. Stocks that pay out more in states in which the aggregate stock-bond correlation is high will be deemed more attractive and their expected returns should be lower. Our hypothesis is then that the stock market-bond market correlation is a risk factor. To test this, we extract the riskless bond-stock market correlation using several different methods that include the BEKK and the Dynamic Conditional Correlation methods. We examine the price of bond-stock correlation risk in the cross section of stock returns. We find that aggregate correlation carries a statistically significant negative price of risk of about 3 percent that cannot be explained by the market return, size, book-to-market, default spread, term spread, unexpected inflation and other known risk factors.

Keywords: Bond Market-Stock Market Correlation, Price of Correlation Risk