Pricing equity-bond covariance risk: Between flight-to-quality and fear-of-missing-out

Abstract

Motivated by Merton (1973), we propose a novel bivariate intertemporal asset pricing model, which relates expected equity and bond market returns to their conditional covariance. Investors’ dynamic hedging demand coincides with covariance risk, which in turn plays a central role in explaining contemporaneous time-variation in expected market returns. Our model predictions are consistent with variations in expected equity and bond returns that include flight-to-quality and fear-of-missing-out episodes, both of which coincide with low levels of equity-bond covariance. We identify determinants of time-variation in conditional covariance and thus potential drivers of flight-to-quality and fear-of-missing-out. Unanticipated changes in expected inflation, market illiquidity and stock market uncertainty predict changes in the equity-bond covariance, where the contribution of each variable is state-dependent. In particular, the non-linear effects of shocks to inflation act as a key driver.