Atwo-factorno-arbitrage modelis usedtoprovide atheoreticallinkbetweenstockandbondmarket
volatility. While this model suggests that short-term interest rate volatility may, at least in part, drive
both stockand bond market volatility, the empirical evidence suggests that past bond market volatility
affects both markets and feeds back into short-term yield volatility. The empirical modelling goes on
to examine the (time-varying) correlation structure between volatility in the stock and bond markets
and finds that the sign of this correlation has reversed over the last 20 years. This has important
implications far portfolio selection in financial markets.
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