Publikation: Perras, P., Wagner, N. (2020): Pricing Equity-Bond Covariance Risk: Between Flight-to-Quality and Fear-of-Missing-Out, Journal of Economic Dynamics and Control (forthcoming): 104009.
Motivated by Merton (1973), this paper proposes a new bivariate intertemporal asset pricing model that considers the equity-bond covariance as an important risk factor in equity and bond pricing. Investors' dynamic hedging demand coincides with the equity-bond covariance, and thus could potentially drive this risk factor in pricing of both equities and bonds. To verify this hypothesis, the model is calibrated using market data. The parameters are found to be significant in the tests, supporting the predictive power of the covariance risk.
Especially interesting and consistent results are seen in the periods of flight-to-quality (FTQ) and fear-of-missing-out (FOMO), which are defined with respect to the investors' hedging demand across these two markets in negative correlation periods. FTQ and FOMO periods are identified with three different proxies to check the robustness of the results and constructed with monthly model estimates, monthly realized variance/covariance using daily data, and with daily model estimates. Regarding potential driving factors of the equity-bond covariance, empirical tests show that unanticipated changes in expected inflation, market illiquidity and stock market uncertainty predict changes in the equity-bond covariance.