Equity Tail Risk in the Treasury Bond Market

TL;DR

This paper investigates how equity tail risk, measured via option-implied volatility, influences US Treasury bond returns and prices, revealing its significant predictive power and market pricing, with implications for investors and cross-market consistency.

Contribution

It introduces a novel measure of equity tail risk and demonstrates its predictive and pricing roles in the US and European government bond markets.

Findings

Equity tail risk significantly predicts Treasury excess returns.

Tail risk is priced in the US government bond market.

Higher perceived tail risk leads to increased Treasury prices.

Abstract

This paper quantifies the effects of equity tail risk on the US government bond market. We estimate equity tail risk with option-implied stock market volatility that stems from large negative price jumps, and we assess its value in reduced-form predictive regressions for Treasury returns and a term structure model for interest rates. We find that the left tail volatility of the stock market significantly predicts one-month excess returns on Treasuries both in- and out-of-sample. The incremental value of employing equity tail risk as a return forecasting factor can be of economic importance for a mean-variance investor trading bonds. The estimated term structure model shows that equity tail risk is priced in the US government bond market and, consistent with the theory of flight-to-safety, Treasury prices increase when the perception of tail risk is higher. Our results concerning the predictive power and pricing of equity tail risk extend to major government bond markets in Europe.