Relating Correlations And Mean Returns Across Stocks And T-Bonds To Implied Volatility, Liquidity, And Hedging
Source: Saint Louis University
Traditional economic fundamentals, in the sense of Campbell and Ammer (1993), seem incapable of explaining recent periods with a sustained negative correlation between stock and T-bond returns. Recent work suggests that flight-to-quality and liquidity pricing influences may have a role in understanding time-varying correlations and mean returns across stock and T- bonds. The authors present new time-series and cross-sectional evidence on this issue by examining the crisis-rich 1997 to 2005 period. They document the following stylized facts in the sample. High levels of stock IV, stock illiquidity, and futures hedging are associated with a sizably negative correlation between subsequent stock and T-bond returns.