Equity Risk and Treasury Bond Pricing

We study the contemporaneous and intertemporal partial relation between T-bond pricing and changes in equity risk, as measured by the implied volatility from equity-index options. Our 1992 to 2007 sample is attractive because of the modest inflation risk and sizable time-series variability in equity risk. Over 1997 to 2007 and for inclusive one-half and one-quarter subperiods, we find that the monthly change in equity risk has a contemporaneous partial negative relation (positive relation) with the monthly change in both the 10-year T-bond yield and the term yield spread (the monthly T-bond futures contract return), while controlling for other bond-pricing factors. In contrast, these patterns are not evident over the relatively lower equity-risk period from 1992 to 1996. Further, we also document that the intertemporal partial relations between the monthly equity-risk change and the subsequent month’s stock-bond correlation and the Tbond futures contract return are both negative. Overall, our findings suggest that T-bonds may serve as hedges against equity risk and that the T-bond risk premium has a partial negative relation with changes in equity risk, at least during times with modest inflation risk and relatively high equity risk. Our findings also suggest that term structure models may need to incorporate equity risk. JEL Classification: G12, G14