TAILIEUCHUNG - Stock Market Uncertainty and the Relation between Stock and Bond Returns

Thenotionthatinflation targeting increases the likelihood of stock market boom- bust episodes contradicts conventional wisdom. We take it that the conventional wisdom is defined by the work of Bernanke and Gertler (2000), who argue that an inflation-targeting monetary authority automatically stabilizes the stock market. The reason for this is that in the Bernanke-Gertler environment, inflation tends to rise in a stock market boom, so that an inflation targeter would raise interest rates, moderating the rise in stock prices | Stock Market Uncertainty and the Relation between Stock and Bond Returns Chris Stivers and Licheng Sun Working Paper 2002-3 March 2002 Working Paper Series Federal Reserve Bank of Atlanta Working Paper 2002-3 March 2002 Stock Market Uncertainty and the Relation between Stock and Bond Returns Chris Stivers University of Georgia Licheng Sun University of Georgia Abstract The authors examine how the co-movement between daily stock and Treasury bond returns varies with stock market uncertainty. They use the lagged implied volatility from equity index options to provide an objective observable and dynamic measure of stock market uncertainty. The authors find that stock and bond returns tend to move substantially together during periods of lower stock market uncertainty. However stock and bond returns tend to exhibit little relation or even a negative relation during periods of high stock market uncertainty. The authors findings have implications for understanding joint cross-market price formation. Further their findings imply that diversification benefits increase for portfolios of stocks and bonds during periods of high stock market uncertainty. JEL classification G11 G12 G14 Key words stock and bond market return linkages stock market uncertainty time-varying volatility We thank Jennifer Conrad Jerry Dwyer Mark Fisher Bill Lastrapes Marc Lipson Joe Sinkey and seminar participants from the Federal Reserve Bank of Atlanta Emory University Georgia Tech Georgia State and the University of Georgia for comments and helpful discussions. The views expressed here are the authors and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors responsibility. Please address questions regarding content to Chris Stivers Department of Banking and Finance Brooks Hall Terry College of Business University of Georgia Athens Georgia 30602 and Federal Reserve Bank of Atlanta visiting scholar 706542-3648 706-542-9434 .

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