Volatility transmission between stock and bond markets

Abstract

A two-factor no-arbitrage model is used to provide a theoretical link between stock and bond market volatility. While this model suggests that short-term interest rate volatility may, at least in part, drive both stock and bond market volatility, the empirical evidence suggests that past bond market volatility affects both markets and feeds back into short-term yield volatility. The empirical modelling goes on to examine the (time-varying) correlation structure between volatility in the stock and bond markets and finds that the sign of this correlation has reversed over the last 20 years. This has important implications far portfolio selection in financial markets.

Identifying safe haven assets for equity investors through an analysis of the stability of shock transmission

“…For the UK, Steeley (2006) finds a reversal in the sign of this correlation, from positive to strongly significantly negative over his twenty year sample. Kim et al, 2006 also find obvious downward trends in time-varying correlations between stock and bond market returns in Europe, Japan and the US.…”

Dynamic spillovers between Nigerian, South African and international equity markets

“…Predicated on a two-factor noarbitrage model, Steeley (2006) The issue of volatility transmission across stock markets within the context of domestic business cycles has also received significant attention. For instance, in the study by Kearny (2000), the transmission of conditional volatility from world equity markets and national business cycle variables to national stock markets is modelled.…”

“…Understanding how African markets interact within and outside the continent not only helps in regulating and formulating market policies but also helps investors to carry out effective trading, portfolio allocation and hedging decisions. Steeley (2006) notes that understanding the nature of linkages between financial markets, whether domestic or international, is important for establishing the limits of diversification, security pricing as well as asset price allocation. This has been reinforced by Diebold and Yilmaz (2015) who note that financial market connectedness is important because it helps in understanding the workings of the markets, and aids successful navigating core financial market activities like risk management, portfolio allocation and asset pricing.…”

Investor sentiment, flight-to-quality, and corporate bond comovement

“…At the individual security level, Acharya et al (2013) find higher inter-market correlation between distressed stocks and corporate bonds in times of market downturns; Nieto and Rodriguez (2015) document common factors driving correlation between US stocks and corporate bonds of the same issuer. Correlations within asset classes are assessed either directly (e.g., Steeley, 2006 for different maturity segments of the UK sovereign bond market) or via common risk factors (e.g., Steeley, 1990;Litterman and Scheinkman, 1991 for UK and US sovereign bonds; Fama and French, 1993;Collin-Dufresne et al, 2001;Elton et al, 2001;Gebhardt et al, 2005;and Lin et al, 2011 for US corporate bonds; Klein andStellner, 2014 andAussenegg et al, 2015 for European corporate bonds). We add to this literature by analyzing correlations within the US corporate bond market, determining and analyzing the correlation of systematic credit risk and liquidity, and interpreting this correlation as a flight-to-quality phenomenon.…”