Cross-Market Hedging

First, we see Fleming, Kirby, and Ostdiek (1998), this article considers that pricing is related

to cross-market hedging. Additionally, Kodres and Pritsker (2002) hold the same conclusion.

Fleming, Kirby, and Ostdiek estimate a model based on the relation between volatility and

information flow, considering cross-market hedging in the stock, bond, and money market.

By using daily returns to measure these linkages across markets and estimating a stochastic

volatility representation of the trading model by means of GMM. It is found that information

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linkages and spillover in the stock and bond markets indeed exist.

Next, Kodres and Pritsker (2002) suggest a rational expectations model of financial

contagion, which is designed to describe price movements over modest periods of time during

which macroeconomic conditions can be taken as given. With wealth effects and asset

substitution effects, a shock in one asset market may generate cross-market asset rebalancing

with pricing influences in other non-shocked asset markets.

More apparently, in the researches of the financial market volatility, the magnitude of the

interaction between international financial markets increases after financial crisis. Masih and

Masih (1997) present the fact that after the crash of the New York Stock Exchange in 1987,

the financial crisis in Mexico in 1994 and the Asian Financial Storm from 1997 to 1998, the

correlation of the international markets is revealed obviously. A possible explanation of such

a phenomenon is the herd instinct - expectation of investors and the effect of trading noise

(King and Wadhwani, 1990). These papers suppose that the factors have greater direct

impacts and enlarge the effect of market contagion in a short term. Another explanation is the

openness of the financial market. Then, Liu and Pan (1997) conclude that a higher openness

results in higher comovement of financial markets after financial crisis. Kanas (1998)

discover the volatility spillover effect in European markets, which is focused on the influence

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of the finance system and suggests that the deregulation of the capital flows, also illustrates

the integration of international financial markets. Longin and Solnik (2001) and Ang and

Chen (2002) research the asymmetry effect in the international equity markets. They find that

the correlation will change under different market conditions. Besides, correlations are

completely different in bull or bear markets.

Then, dynamic cross-market hedging seems likely to be associated with time-varying stock

market uncertainty in the sense of Veronesi (1999), (2001) and also represented in David and

Veronesi (2001), (2002). These studies characterize state-uncertainty in a two-state economy

where dividend growth changes between unobservable states. The economic-state uncertainty

is important in realizing price formation and the dynamic structure of returns. Veronesi (2001)

considers that investors make the aversion to state-uncertainty and discuss that the aversion to

state-uncertainty generates a high equity premium and a high return volatility, because it

increases the sensitivity of the marginal utility of consumption to news. In addition, it also

lowers the interest rate due to the increases of the demand for bonds from investors who are

concerned about the long-run mean of the consumption.

David and Veronesi (2001) investigate that the volatility and covariance of stock and bond

returns vary with uncertainty about future inflation and earnings. Their uncertainty measures

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are derived both from survey data at the semi-annual and quarterly frequency from estimation

of their model at the monthly horizon. It is revealed that uncertainty appears more important

than the volatility of fundamentals when explaining volatility and covariance. In David and

Veronesi (2002), which argue that economic-uncertainty should be positively related to the

implied volatility from stock options.

Furthermore, Chordia, Sarkar, and Subrahmanyam (2001) present evidence consistent with

a linkage between dynamic cross-market hedging and uncertainty. They explore both trading

volume and bid-ask spreads in the stock and bond markets respectively from June 1991 to

December 1998. They suggest that the correlation between stock and bond spreads as well as

between stock and bond volume changes increase dramatically during crises. During the

periods of crises, it is found that there is a decrease in mutual fund flows to equity funds and

an increase in fund flows to government bond funds. Their results are consistent with

increased investor uncertainty, which leads to frequent and related portfolio reallocations

during such the financial crises.

Finally, see Bekaert and Grenadier (2001) and Mamaysky (2002) for instances of recent

research that jointly stock and bond prices are considered in a formal structural economic

model. These papers focus on the common movement of expected returns for both stocks and

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bonds, as well, identify common and asset specific risk. Accordingly, the empirical studies of

their papers consider monthly and annual returns. While these models do not seem in accord

with the direct explanation for the time-varying daily comovements, the models do provide

useful intuition that supports our further discussion in models in the Section III. Mamaysky

(2002) proposes an economy where there are certain risk factors that are common to both

stock and bonds, while another set of risk factors that are only unique to stocks. We adopt this

conjecture in our subsequent discussion, including the concern of common and stock-specific

risk factors. Bekaert and Grenadier (2001) explore stock and bond prices within the joint

framework of an affine model of term structure, present-value pricing of equities, and

consumption-based asset pricing. They study three different economies, finding that the

“Moody” investor economy presents the best fit of the real unconditional stock-bond returns

correlation. In this economy, prices are determined by dividend growth, inflation, and

stochastic risk aversion where risk aversion is likely to be negatively correlated with shocks to

dividend growth. It is implied that shocks to dividend growth may be affected by changing

risk premia, moreover, changing in cross-market hedging between stocks and bonds.

Connolly, Stivers, and Sun (2005) suggest that the correlation of U.S. stock and bond

returns shifting from positive to negative is corresponsive to the periods of low to high market

uncertainty. They use stock and bond data over the period of 1986 to 2000. It is examined

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whether time-variation in the daily stock and Treasury bond returns comovements can be

linked to measures of stock market uncertainty. They find a negative relation between the

uncertainty measures and the future correlation of stock and bond returns. In the conclusion,

their findings suggest that stock market uncertainty has significant influences on cross-market

pricing. Besides, the stock-bond diversification benefits more from the increase with stock

market uncertainty.