Information and Volatility Linkages in the Stock, Bond, and Money Markets

NOTE: The following is a description of the paper and is not the actual abstract. This article examines the nature of volatility linkages in an economy with multiple securities markets. The analysis is based on the relation between volatility and information flow. To formalize this relation, we develop a simple model of speculative trading where the traders take positions in one or more futures contracts based on their current expectations and their risk tolerances. As new information is released, they update their expectations, revise their demands, and trade accordingly. Under the model, information generates market linkages in two ways. First, information can simultaneously affect expectations about the risk and return characteristics of multiple contracts (i.e., the information is common across markets). Second, information can directly affect expectations in only one market but impact other markets through hedging demand (i.e., there is an information spillover between markets). In frictionless markets, the model predicts that hedging causes complete information spillover, leading to perfectly correlated volatility changes across markets. In practice, however, institutional factors and market frictions will limit the impact of cross-market hedging and preclude complete spillover. As a result, the model predicts strong volatility linkages in markets where the hedging benefits are large and the hedging costs are small. We use a stochastic volatility representation of the model to estimate the volatility linkages for three futures markets where we expect both common information and information spillover to be important: the stock, bond, and money markets. The results are generally supportive of our model. The time-series properties of returns are similar to those predicted by the model and the volatility linkages between markets are strong. In addition, subperiod analysis suggests the strength of the linkages increased substantially following the 1987 stock market crash.