Regime-Switching in Stock Index and Treasury Futures Returns and Measures of Stock Market Stress

We investigate bivariate regime-switching in daily futures-contract returns for the US stock index and ten-year Treasury notes over the crisis-rich 1997-2005 period. We allow the return means, volatilities, and correlation to all vary across regimes. We document a striking contrast between regimes, with a high-stress regime that exhibits a much higher stock volatility, a much lower stock-bond correlation, and a higher mean bond return. The high-stress regime is associated with higher average values of stock-implied volatility, stock illiquidity, and stock and bond futures trading volume. The lagged implied volatility from equity-index options is useful in modeling the time-varying transition probabilities of the regime-switching process. Our findings support the notions that: (1) stock market stress can have a material influence on Treasury bond pricing, and (2) the diversification benefits of combined stock-bond holdings tend to be greater during times with relatively high stock market stress