A contingent claims approach to the determinants of the stock-bond return relationship

Abstract

This paper decomposes two effects on a firm's stock and bond returns -the effect of firm's future cash flow and the effect of business risk to study the relationship between the returns of stocks and bonds issued by the same firm. Based on the contingent claims option pricing theory, we employ firm-level data and an event study methodology, and generate hypotheses regarding the stock-bond return relationship. We show that, by controlling for firm's leverage, firm's future cash flow has a simultaneous positive effect on firm's stock and bond returns, whereas firm's business risk has a decoupling effect on stock and bond returns.In addition, we provide evidence for the "flight to quality" hypothesis at a firm-specific level.Our findings complement the literature of stock and bond correlation within a theoretical framework.Keywords: stock-bond relationship; Contingent claims analysis; Option pricing theory; firm performance; business risk JEL Classification: C01; G14; G32 2 IntroductionIn this paper, we investigate the determinants of firms' stock-bond return relationship within the contingent claims analysis (henceforth, CCA) framework. The relationship between stock and bond returns has undergone extensive empirical investigations at both aggregate and firm level. At aggregate level, there is a consensus that the correlation of bonds and stock returns is state dependent and is affected by macroeconomic factors (see Barsky 1989; Cappiello et al. 2006 andLee et al. 2011). At firm level, several studies report a time-varying correlation between stock and bond returns issued by the same firm (see Shane 1994;Hotchkiss and Ronen 2002;Kwan 1996;Alexander et al. 2000 andBao andHou 2013). Our study complements the latter literature by explaining why the correlation between these two sets of asset returns is time-varying using firm fundamentals from an explicit CCA perspective.For this purpose, we re-visit the classic CCA, and use its theoretical underpinnings to infer the effects of a firm's future cash flow and business risk on the firm's stock-bond return relationship. CCA is a generalization of the option pricing theory pioneered by Black and Scholes (1973) and Merton (1973), that has been applied to a wide variety of contingent claims, such as corporate bonds and equities (see Merton 1974, Galai and Masulis, 1976and Koussis and Martzoukos, 2012. In relation to our study, the CCA option pricing model suggests that that holders of risky corporate bonds can be thought of as issuers of call options to the holders of a firm's equity, where the underlying asset is the market value of the firm; the holders of the firm's equity will therefore take the residual of the firm's total asset at maturity. Assuming firm value is irrelevant to firm's capital structure, Merton (1974) indicates that bond returns have a positive relationship with the return of firm assets and a negative relationship with changes in the volatility of firm assets. Galai and Masulis (1976) propose that stock and bond returns are positively rela...