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Equity risk as a determinant of future term-structure volatility

Journal of Financial Markets. September 1, 2015

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Recent literature indicates both that bond-market volatility is not spanned by the cross-section of bond yields, contrary to implications of affine term-structure models, and that flight-to-quality pricing influences apparently link the stock and bond markets. With this motivation, we investigate whether equity risk is a determinant of future Treasury term-structure volatility over the recent 1997-2011 period, in a framework that controls for bond-market variables that are suggested by the literature. We find that equity risk, measured by the implied volatility from equity-index options, contains incrementally reliable information for the subsequent volatility of: (1) T-bond returns, measured by the returns of 10-year T-note futures contracts, (2) the term-structure’s level, measured by the term-structure’s first principal component, and (3) the term-structure’s slope, measured both by the term-structure’s second principal component and a ’10-year minus 6-month’ term yield spread. Our intertemporal findings support the notion that equity-risk can help understand movements in the term-structure, beyond an approach that only looks at the bond market in isolation.