 Pricing equity-bond covariance risk: Between flight-to-quality and fear-of-missing-outPatrizia Perras and Niklas Wagner Journal of Economic Dynamics and Control, 2020, vol. 121, issue C Abstract: Motivated by Merton (1973), we propose a novel bivariate intertemporal asset pricing model, which relates expected equity and bond market returns to their conditional covariance. Investors’ dynamic hedging demand coincides with covariance risk, which in turn plays a central role in explaining contemporaneous time-variation in expected market returns. Our model predictions are consistent with variations in expected equity and bond returns that include flight-to-quality and fear-of-missing-out episodes, both of which coincide with low levels of equity-bond covariance. We identify determinants of time-variation in conditional covariance and thus potential drivers of flight-to-quality and fear-of-missing-out. Unanticipated changes in expected inflation, market illiquidity and stock market uncertainty predict changes in the equity-bond covariance, where the contribution of each variable is state-dependent. In particular, the non-linear effects of shocks to inflation act as a key driver. Keywords: Covariance risk; Dynamic hedging; Equity premium; Fear-of-missing-out (FOMO); Flight-to-quality (FTQ) (search for similar items in EconPapers) Downloads: (external link) Related works: Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text Persistent link: https://EconPapers.repec.org/RePEc:eee:dyncon:v:121:y:2020:i:c:s0165188920301779 DOI: 10.1016/j.jedc.2020.104009 Access Statistics for this article Journal of Economic Dynamics and Control is currently edited by J. Bullard, C. Chiarella, H. Dawid, C. H. Hommes, P. Klein and C. Otrok More articles in Journal of Economic Dynamics and Control from Elsevier |
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