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Risk Premia and the Dynamic Covariance between Stock and Bond Returns

Published online by Cambridge University Press:  06 April 2009

John T. Scruggs  and
Paskalis Glabadanidis
John T. Scruggs
Affiliation:
[email protected], Terry College of Business, University of Georgia, Brooks Hall, Athens, GA 30602;
Paskalis Glabadanidis
Affiliation:
[email protected], Onlin School of Business, Washington University in St.Louis, Campus Box 1133, One Brookings Drive, St.Louis, MO 63130.
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Abstract

We investigate whether intertemporal variation in stock and bond risk premia can be explained by time-varying covariances with priced risk factors. We estimate and test a conditional two-factor variant of Merton's ICAPM in which excess returns on an equity index and a long-term government bond portfolio proxy for risk factors. Conditional second moments follow the asymmetric dynamic covariance (ADC) model of Kroner and Ng (1998). We find that conditional bond variance responds symmetrically to bond return shocks but is virtually unaffected by stock return shocks, while conditional stock variance responds asymmetrically to both stock and bond return shocks. Models that impose a constant correlation restriction on the covariance matrix between stock and bond returns are strongly rejected. We conclude that the conditional two-factor model fails to adequately explain intertemporal variation in stock and bond risk premia.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 38 , Issue 2 , June 2003 , pp. 295 - 316
Copyright
Copyright © School of Business Administration, University of Washington 2003

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