Can No-Arbitrage SDF Models with Regime Shifts Explain the Correlations Between Commodity, Stock, and Bond Returns?

Marta Giampietro, Massimo Guidolin and Manuela Pedio ()

No 1619, BAFFI CAREFIN Working Papers from BAFFI CAREFIN, Centre for Applied Research on International Markets Banking Finance and Regulation, Universita' Bocconi, Milano, Italy

Abstract: We investigate whether it is possible to find a Stochastic Discount Factor (SDF) that jointly prices the cross-section of eight U.S. portfolios of stocks, Treasuries, corporate bonds, and commodities and replicates their observed moments, and especially correlations. We use the first three principal components extracted from a set of 112 U.S. macro variables as pricing factors. We also introduce commodity-based factors in the SDF, motivated by commodity pricing theories and we use them either separately or in conjunction with the macro-based ones. We report that it is not impossible to find a set of macroeconomic factors able to jointly price the cross section of stocks, bonds, and commodities; however, this task is accomplished by a small set of commodity-based factors. Observed correlations for commodities are perfectly matched by a parsimonious, single state, diagonal factor VAR model where only three commodity-based factors enter the SDF. While introducing regimes does not improve the performance in all cases, they could be beneficial to replicating correlations among commodity and bond portfolios.

Pages: 37 pages
Date: 2015
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