A Vector Error Correction Model (VECM) Approach to Investigate the Linear Behaviour of Stocks, Bonds and Hedge Funds

One of the major concerns in todays’ world of economic finance, especially investments in asset classes like stocks and bonds, is whether the returns on these asset classes are linear or non-linear. To test the linearity behaviour, this paper employs the Granger causality test (Granger, 1969) in the Vector Error Correction Model (VECM) scheme between stock, bond and hedge fund returns. The findings from the empirical evidence reveal that in bivariate and multivariate mode there is bidirectional short-run linear causality between stocks, bonds and hedge funds. In addition, the result also highlights that there exists a bidirectional long-run linear causality among stocks bonds and hedge funds while there is a unidirectional long-run linear causality between stocks and hedge funds. The outcome of this study is extremely useful to the institutional asset portfolio managers and also to the individual investors as it helps them in understanding the capital market structure better