The bond-stock yield differential as a risk indicator in financial markets

Giorgio Consigli, Leonard C. MacLean, Yonggan Zhao and William T. Ziemba

Journal of Risk

Abstract: ABSTRACT The trading prices for securities in financial markets can exhibit sudden shifts or reversals in direction. In this paper a methodology for asset price dynamics is presented where the diffusive component is combined with a risk process. The risk process accommodates deviations from an equilibrium process and reversions. The bond-stock yield differential is considered as a risk factor affecting the risk process. An approach using a "peaks over threshold" technique and conditional maximum likelihood is used to estimate parameters in the model. Numerical results for the period 1985-2004 in the US market validate the effectiveness of the model.

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