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Regime Switching and Stock-Bond Co-Skewness

If asset returns have systematic skewness, expected returns should include rewards for accepting this risk. This idea can be extended to two different asset classes: stocks and bonds. There are two systematic skewness measures: stock co-skewness (the relation between stock return and bond volatility) and bond co-skewness (the relation between bond return and stock volatility). With monthly data from the past 150 years for both the U.S. and U.K. markets, we characterize conditional co-skewness between stock and bond premiums using a bivariate regime-switching model. Both U.S. stock and bond co-skewnesses command negative ex ante risk premiums. If these measures increase by their one standard deviation, the expected stock and bond premiums will decrease by 4.5 percent and 0.6 percent per year respectively. The cross-market co-skewness effects are also present in U.K. data.