Implied volatility, risk reversal and the stock - bond return relation

Abstract

In this project the time-variation in the co-movements between daily stock and Treasury bond returns over 1986-2005 was studied. The main task was to examine whether variation in stock bond return dynamics can be linked to the implied volatility (IV) from equity index options and to the detrended stock turnover (DTVR). From our regressions it was found out that the Implied Volatility and the detrended stock turnover are both negatively associated with the future correlation between stock and bond returns. Furthermore, it was found out that bond returns tend to be relatively high during days when Implied Volatility increases. The above findings have implications for understanding that times of high stock market uncertainty are also times with the relative attractiveness of stocks and bonds. Therefore, there is a positive effect of implied volatility of stocks on expected bond returns, since investors switch to bonds.