An econometric model of nonlinear dynamics in the joint distribution of stock and bond returns



This paper considers a variety of econometric models for the joint distribution of US stock and bond returns in the presence of regime switching dynamics. While simple two- or three-state models capture the univariate dynamics in bond and stock returns, a more complicated four-state model with regimes characterized as crash, slow growth, bull and recovery states is required to capture their joint distribution. The transition probability matrix of this model has a very particular form. Exits from the crash state are almost always to the recovery state and occur with close to 50% chance, suggesting a bounce-back effect from the crash to the recovery state. Copyright © 2006 John Wiley & Sons, Ltd.