The bond-stock yield differential as a risk indicator in financial markets

Giorgio Consigli, Leonard C. MacLean, Yonggan Zhao, William T. Ziemba

Abstract

ABSTRACT

The trading prices for securities in financial markets can exhibit sudden shifts or reversals in direction. In this paper a methodology for asset price dynamics is presented where the diffusive component is combined with a risk process. The risk process accommodates deviations from an equilibrium process and reversions. The bond-stock yield differential is considered as a risk factor affecting the risk process. An approach using a "peaks over threshold" technique and conditional maximum likelihood is used to estimate parameters in the model. Numerical results for the period 1985-2004 in the US market validate the effectiveness of the model.