Stock And Bond Price Dynamics-Evidence From An Emerging Economy

Abstract

The motivation for this study is that real stock prices are observed to overreact to changes in interest rates. The real stock prices drop when long-term interest rates rise.  It has been observed that bonds and stock prices are typically studied in isolation. The present paper attempts to analyze the dynamic linkages between stock and bond prices in India.

One of the important contributions of this study is that in India, very little/almost no work has been done to understand the dynamics of the stock and bond prices after the recent recession. The present study examined the bivariate causal relationship between stock prices and bond prices.  In the long term; i.e., periods from 2004 to 2007 and 2008 to 2009, there is no causality from stock market to bond market and vice versa. However, it is found that the bond and stock prices had a bivariate causality in the year 2009 and univariate causality in 2010. The results are interesting and support the view that excess volatility causes granger between the stock and bond markets. This can be inferred as a result of recession investors moving to bond markets and after the signs of recovery the investors might be returning to the stock markets.

It is also evident that short-term interest rates have power to forecast short-term stock returns and risk premiums on observation of co-movement between stock and bond prices. This is reiterated by many empirical studies that have shown that the term “structure of nominal interest rates” contains information potentially useful for the conduct of monetary policy.