On Risk Premia and Volatility Transmission Across the Stock and Bond Markets

Abstract

This paper analyzes risk premia and volatility transmission across the stock and bond markets within an expected return beta representation of the conditional capital asset pricing model. Time variation in the market price of risk is characterized by a two state Markov regime switching process, while time variation in conditional betas is characterized by an asymmetric general dynamic covariance process. On the basis of estimated state dependent generalized impulse response functions, we find evidence of a flight to quality phenomenon, whereby investors shift funds from the stock market to the bond market in response to high stock market volatility. Our impulse response analysis also suggests that the degree of risk diversification achieved by cross market hedging is lowest when it is most desirable.Risk premia and volatility transmission; Stock and bond markets; Conditional capital asset pricing model