Equity Risk and Treasury Bond Pricing
We show that changes in equity risk are substantially tied to changes in the slope of the Treasury term structure over the recent 1997 to 2007 period, even after controlling for Treasury-market state variables and contemporaneous bond-market variables suggested by the literature. Risk is measured by the implied volatility from equity-index options and 10-year T-Note futures options. We find a partial negative relation between monthly changes in equity risk and monthly changes in the term-structure’s slope, as measured both by the term-structure’s second principal component and the term yield spread. Further, equity risk contains reliable forward-looking information about the volatility of the unexplained change in the term-structure’s slope. Our evidence suggests that equity risk changes are reliably tied to changes in the spread between equity and T-bond risk premia and that changes in equity risk can be important for understanding movements in the Treasury term structure.
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