Flights and CAViaR - Financial market stability and the stock-bond return relation

Abstract

PURPOSE OF THE STUDY

This paper investigates the intranational dynamic relationship between daily stock and government bond returns of selected countries between January 1, 1999 and December 31, 2010 to assess financial market stability in different countries and market conditions. The underlying hypothesis of this paper is that the financial markets of the world’s most advanced economies exhibit financial market stability even under extreme market conditions and potentially systemic events. The econometric framework employed to assess whether a country exhibits financial market stability or not includes modeling the time-varying conditional intranational stock-bond correlations, testing for the intranational flights between stocks and bonds, and modeling the conditional autoregressive value at risk (CAViaR) of equally weighted intranational stock-bond portfolios. These methodologies represent one of the most prominent and current tools in the field of financial econometrics and are commonly used by researchers and practitioners all around the world. Importantly, they all have the potential to provide valuable information for investors, policy makers and regulatory authorities about the cross-sectional dimension of systemic risk for assessing financial market stability under extreme market conditions and potentially systemic events.

DATA

The data employed in this paper consists of daily observations of national local currency denominated stock and government bond market total return indices of Australia, Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Spain, Sweden, Switzerland, the United Kingdom (UK), and the United States (US) from January 1, 1999 to December 31, 2010 (3131 observations). The stock market indices are Datastream-constructed value-weighted total market indices representing the total return on a well-diversified national equity portfolio covering a minimum of 75% - 80% of the total market capitalization of each market. The bond market indices are Datastream-constructed 10-year constant maturity total return indices consisting only of the most liquid government bonds following the European Federation of Financial Analysts Societies (EFFAS) methodology.

RESULTS

The empirical results show that the world’s most advanced economies, except Italy and Spain, exhibit financial market stability under extreme market conditions and potentially systemic events as assessed by their intranational stock-bond return relations. In the financially stable countries under extreme market conditions and potentially systemic events, the conditional intranational stock-bond correlations tend to stay below or close to zero, the intranational flights between stocks and bonds tend to rather reduce than aggravate the propagation of shocks, and the CAViaR of equally weighted intranational stock-bond portfolios resemble each other to a high degree without showing hardly any excessive divergent spillover effects. In Italy and Spain, the reverse applies. Overall, these results in favor of prevailing financial market stability even under extreme market conditions and potentially systemic events are relatively well in line with the rare empirical literature on financial market stability with the emphasis on cross-asset linkages in developed markets.