J Real Estate Finan Econ (2012) 45:491521 DOI 10.

1007/s11146-010-9265-0

Asymmetric Correlation and Volatility Dynamics among Stock, Bond, and Securitized Real Estate Markets
Jian Yang & Yinggang Zhou & Wai Kin Leung

Published online: 1 September 2010 # Springer Science+Business Media, LLC 2010

Abstract We apply a multivariate asymmetric generalized dynamic conditional correlation GARCH model to daily index returns of S&P500, US corporate bonds, and their real estate counterparts (REITs and CMBS) from 1999 to 2008. We document, for the first time, evidence for asymmetric volatilities and correlations in CMBS and REITs. Due to their high levels of leverage, REIT returns exhibit stronger asymmetric volatilities. Also, both REIT and stock returns show strong evidence of asymmetries in their conditional correlation, suggesting reduced hedging potential of REITs against the stock market downturn during the sample period. There is also evidence that corporate bonds and CMBS may provide diversification benefits for stocks and REITs. Furthermore, we demonstrate that default spread and stock market volatility play a significant role in driving dynamics of these conditional correlations and that there is a significant structural break in the correlations caused by the recent financial crisis. Keywords CMBS . REITs . Dynamic conditional correlation . Macroeconomic variables
J. Yang The Business School, University of Colorado Denver, Denver, CO 80217-3364, USA e-mail: Jian.Yang@ucdenver.edu J. Yang Lingnan College, Sun Yat-Sen University, Guangzhou, Guangdong 510275, Peoples Republic of China Y. Zhou (*) The Faculty of Business Administration, Chinese University of Hong Kong, Shatin, Hong Kong, Peoples Republic of China e-mail: ygzhou@baf.cuhk.edu.hk W. K. Leung School of Hotel and Tourism Management, Chinese University of Hong Kong, Shatin, Hong Kong, Peoples Republic of China e-mail: Leungwk@cuhk.edu.hk

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JEL Classifications G11 . C32

Introduction REITs (Real Estate Investment Trusts) and CMBS (Commercial MortgageBacked Securities) are securitized real estate equity and debt representing claims on real property or commercial mortgages. In the last two decades, REIT and CMBS markets have grown very fast and become important asset classes. The National Association of Real Estate Investment Trusts (NAREIT) shows that the market capitalization outstanding of US REITs increased from $8.7 billion at the end of 1990 to $438 billion at the end of 2006, and then decreased to $192 billion at the end of 2008 due to the financial crisis. According to the Commercial Mortgage Securities Association (CMSA), the CMBS market has grown from $41.6 billion in CMBS outstanding in 1990 to $913 billion in 2007. In addition, these asset classes might have emerged to provide additional diversification benefits because they offer investment opportunities in diversified real estate market pools and maintain rather strong links with the direct private real estate market. Nevertheless, such diversification opportunities might have changed during the recent financial crisis, which originated in the US real estate market. In the literature, it is widely recognized that correlations and linkages among different asset classes evolve over time as macroeconomic conditions change and new information is released (e.g., Brenner et al. 2009; Yang et al. 2009). Understanding the nature of the time variation in the correlations between different assets has crucial implications for asset allocation and risk management. In this context, have REITs and CMBS become more correlated over time with general financial markets so that their diversification potential is diminished? Do REITs and CMBS exhibit asymmetry not only in conditional volatilities, but also in the conditional correlation? What causes time-varying conditional correlation between REITs, CMBS, and general financial markets? Does the recent financial crisis play any role in driving the correlation structure? By answering the above questions, this paper contributes to the literature in the following aspects. First, to the best of our knowledge, this is the first comprehensive study to explore conditional correlation dynamics among CMBS, REITs, and general financial markets (stocks and bonds).1 As reviewed below, previous studies primarily focused on linkages between REITs and capital markets, especially between REITs and the stock market, at the monthly frequency. A
1 Following a large body of the literature as reviewed below, we investigate dynamic interactions between these asset classes at the aggregate level in this study. Such an investigation is interesting in itself, as investors with passive portfolio management style are most interested in price dynamics of asset classes at the aggregate level. Certainly, within each of these asset classes, there are different subgroups of securities with certain common characteristics that may respond to economic shocks in substantially different manners. Allowing for such heterogeneity within each asset class is obviously an interesting extension of our study. Nevertheless, due to serious limitations of GARCH models when applied to a high-dimensional system (as discussed below), such a task is practically infeasible, particularly given the sample size of this study.

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notable exception is Cotter and Stevenson (2006), who examined daily conditional correlation between US REITs and the stock market. Focusing on higher-frequency dynamic linkages may be important for the purpose of this study, as information transmission between various asset markets is perceived to be speedy due to the widespread use of information technology. More importantly, little research has been done to examine in-depth dynamic linkages between CMBS and other asset markets, although some recent studies touched on the issue. Xu (2007) showed that historical unconditional correlations of US CMBS returns from 1997 to 2006 were negative with S&P500 returns and positive with US bond market returns. Kau et al. (2009) suggested a link between REITs and CMBS by showing that REIT property-type indices may be useful in updating the unobservable current loan-tovalue ratio, which is a key state variable driving CMBS defaults. An et al. (2009) also suggested that the commercial mortgage-Treasury rate spread might be affected by the corporate bond credit spread and commercial real estate volatility as proxied by REITs index volatility. Thus, it is natural to extend the earlier analysis focusing on REITs to include CMBS since both REITs and CMBS are securitized real estate products. In this paper, we comprehensively study a fivevariable system: CMBS, equity REITs, mortgage REITs, stocks, and corporate bonds. The correlation dynamics we document support the general patterns found by the previous REIT studies and also add new evidence to the literature when the CMBS market is included. Second, extending the earlier literature, we use the multivariate asymmetric generalized dynamic conditional correlation (AG-DCC) GARCH model of Cappiello et al. (2006) (combined with allowance for asymmetric volatility as in Glosten et al. (1993)) to investigate whether all conditional correlations and volatilities show asymmetry and how similar the patterns of correlations are across CMBS, REITs, and general financial markets. While a few recent studies use the DCC model of Engle (2002) to explore correlation dynamics in the real estate literature (e.g., Liow et al. 2009; Yavas and Yildirim 2009; Case et al. 2009), little research has been done to explore the asymmetric conditional correlation dynamics, with the notable exception of Michayluk et al. (2006). Nevertheless, the Asymmetric Dynamic Covariance model used in Michayluk et al. (2006) (though flexible) may involve numerous parameters, thereby requiring more data points for efficient estimation and thus encountering serious challenges and difficulties in estimating a higher-dimension system. By contrast, we apply AGDCC GARCH specifications with many fewer parameters and much greater ease in estimation, while maintaining the essential flexibility in the model specifications that enables us to investigate the presence of asymmetric responses in conditional variances and correlations to negative returns. Finally, extending the existing literature, we employ (lagged) observable macroeconomic variables as instruments to predict daily conditional correlations between CMBS, REITs, and general financial markets. This may render our findings both more straightforward in forecasting future correlations on a daily basis and more useful for active portfolio management. Building on the literature, we consider default and term spreads for business cycle factors (Chen et al. 1986; Fama and French 1989; Chen et al. 1997; Ling and Naranjo 1999), stock market volatility for volatility factor (Connolly et al. 2005), and mortgage spread for real estate sector

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specific factor. We show that the default spread and stock market volatility are particularly strong predictors of almost all time-varying pairwise correlations between the assets under consideration, although the other factors also have predictive power for some of the pairwise correlations. Moreover, the recent financial crisis starting from 2007 has caused a significant structural break in the correlation structure. In particular, the term spread became a strong predictor for conditional correlations between various markets under considerations after the crisis started (presumably in early August 2007), while the stock market volatility lost its predictive power. The rest of the paper is organized as follows: Literature Review reviews the literature; Data describes the data; Econometric Methodology discusses econometric methodology; Empirical Results presents empirical results; and, Conclusions makes concluding remarks.

Literature Review The relationship between real estate securities and general financial markets has been extensively explored, with much of the literature focusing on the bivariate relationship between real estate securities (e.g., REITs) and general stock markets. As reviewed below, existing studies can be generally divided into two categories, which are based on asset pricing models or time series analysis. The asset pricing models have been applied to investigate integration versus segmentation between the real estate market and the general financial markets since the first study of Liu et al. (1990) on this topic. Liu et al. used a single-factor model and reported that the US securitized real estate market integrates with the stock market, while the US private commercial real estate market is segmented from the stock market. Peterson and Hsieh (1997) showed that the risk premiums on equity REITs are significantly related to three Fama-French factors driving common stock returns, while mortgage REIT risk premiums are significantly related to two bond market factors as well as the three stock market factors. Using a series of commonly used multifactor asset pricing models, Ling and Naranjo (1999) confirmed that US REITs are integrated with the stock market and the degree of such integration has significantly increased during the 1990s, while there is little evidence for integration between the real estate and stock markets when appraisal-based real estate returns are used. Using a multifactor model where stock, bond, and direct real estate returns as proxies for underlying state variables determining these asset prices, Clayton and Mackinnon (2003) reported that while through 1970s and 1980s the US NAREIT returns were driven largely by the same economic factors that drive large cap stocks, they are more closely related to both small cap stock and real estate-related factors in the 1990s. Downs and Patterson (2005) employed a generalized asset pricing model (i.e., a discount factor model) and showed that US REIT returns from 1972 to 1991 cannot be fully explained by stock and bond returns. Instead of using asset pricing models, many researchers have employed an important time series concept of cointegration (and its variations) to explore whether there exists a long-run relationship between real estate and capital market prices (typically at the monthly frequency), which carries implications for

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the long-run diversification potential of real estate to investors. Glascock et al. (2000) reported bivariate cointegration of the REIT and S&P 500 indices during the second subperiod of 19921996 but not during the first subperiod of 1972 1991. They also found bivariate cointegration between the REITs and the bond market during the first subperiod but not during the second subperiod. Their results tend to suggest diminishing diversification benefits of REITs to stock market investors after 1992. By contrast, Chaudhry et al. (1999) reported evidence of multivariate cointegration among the appraisal-based real estate market, the stock market, the bond market and T-bills. Wilson et al. (1998) reported that even with allowance for a possible structural break in cointegration tests, the real estate and stock markets are generally not cointegrated in three developed countries: the US, the UK, and Australia. Noting the limitations of conventional cointegration tests, Okunev and Wilson (1997) showed that while there is no evidence of a long-run relationship between US REITs and the general stock market based on the conventional tests, positive evidence was detected when a model based on the notion of a fractional cointegration was employed to allow for a nonlinear relationship between the real estate and stock markets. Also using the notions of cointegration and fractional cointegration, Liow and Yang (2005) further demonstrated the existence of longterm co-memories and short-run dynamic adjustments between securitized real estate and stock markets in four Asian economies: Japan, Hong Kong, Singapore, and Malaysia. Other time series techniques are also employed to examine further different aspects of the dynamic relationship between real estate and general financial markets. Kallberg et al. (2002) conducted structural break tests and reported regime shifts in returns and volatility relationships between real estate and stock markets in eight Asian markets. Based on a bivariate GARCH model, Cotter and Stevenson (2006) found that daily REIT-stock correlations generally increased during the period from 1999 to 2005. Applying a multivariate DCC-GARCH model to a seven asset system, Huang and Zhong (2006) argued that during the period from 1999 to 2005, daily conditional correlation between REIT and US equity was always positive but had a positive trend and daily correlations between REIT and US bond fluctuated around zero. Also using a DCC-GARCH model, Case et al. (2009) examined monthly conditional correlations between US stock and REIT markets from 1972 to 2008 and explored the implications for portfolio allocation.

Data Returns and Instrument Variables The index return data come from two sources. Stock and REIT index returns are from Bloomberg: S&P500 total return index, the FTSE NAREIT US Equity REITs total return index, and mortgage REITs total return index. From LehmanLive, we obtain Barclays Capital (formerly Lehman Brothers) US corporate bond and investment-grade CMBS total return indices. Although there are other indices covering a longer period, the Barclays Capital CMBS index has been a new

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benchmark for the CMBS market since 1999 (Baek and Golbin 1999). We focus on investment-grade CMBS because it dominates the CMBS market, accounting for about 94% of all CMBS in terms of outstanding amount.2 The daily returns are calculated as the log differences of the various return indices. The return data span from March 1, 1999 to June 30, 2008. The sample starts from March 1999 because the CMBS index we use is only available since the end of February 1999. Also, the sample ends on June 30, 2008 because of CMBS data availability. We also collect and construct the following economic indicators based on daily data available at Bloomberg: (1) The default spread (DEF) is measured as the difference between Moody BAA and AAA bond yields. This spread is an indicator of perceived business conditions in the general economy. If business conditions are poor, then there is an increase in the likelihood of default in lower quality corporate bonds, which leads to increase in default spread. (2) The term spread (TERM) is measured as the difference between the 10-year and 3-month Treasury bill yields. As the default spread measures long term business conditions, the term spread is a proxy for short term business conditions. (3) The mortgage spread (MGTB) is measured as the difference between 30-year mortgage rate and 30-year Treasury bond yield. (4) The stock market volatility can be measured by the Chicago Board Option Exchange S&P500 volatility index (VIX). The VIX reflects market estimate of future volatility, based on the weighted average of the implied volatilities for a wide range of strikes. Often referred to as the fear index, VIX is a widely watched measure of the market risk or uncertainty, as a central ingredient in investors appetite for exposure to risky assets. A number of studies on the stock, bond and real estate markets (Chen et al. 1986; Fama and French 1989; Chen et al. 1997; Ling and Naranjo 1999) identified default and term spreads as business cycle risk factors in driving asset prices. While other macroeconomic variables have been used in the literature, the data typically exist only at the monthly frequency. By contrast, the financial market-based macroeconomic indicators such as the term spread and the default spread are available at the daily frequency. Also, recent literature (e.g. Connolly et al. 2005) showed that stock market volatility may be an important factor driving stock-bond correlations. Furthermore, the mortgage spread may also be considered as a sector-specific factor since our study focuses on securitized real estate products. Although the mortgage spread is an indicator of residential rather than commercial real estate market conditions, it is the best instrument we can get at daily frequency to proxy for the
2 A number of specific criteria apply to construction of the Barclays Capital (formerly Lehman Brothers) CMBS investment grade index: (1) all CMBS securities are rated investment grade by Moodys (BBB or higher) and offered publicly; (2) all transactions must be private label. No agency transactions will be included; (3) the collateral for each transaction must be new origination; (4) each original aggregate transaction size must be at least $500 million and aggregate outstanding transaction sizes must be at least $300 million; (5) all certificates must be either fixed rate, weighted average coupon (WAC) or capped WAC securities. No floating rate certificates will be included; (6) all certificates must have an expected maturity of at least 1 year.

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real estate sector-specific factor. Finally, note that we also experimented with including many other economic variables used in the literature. Nevertheless, they do not further improve the prediction for the correlations given the four instrument variables, and thus do not affect the main results reported below. Summary Statistics Panel A of Table 1 reports the summary statistics of asset returns. During the sample period, US stocks yielded the lowest average daily return of 0.01% while equity REITs yielded the highest average daily return of 0.05%. Corporate bonds and IG CMBS had similar average daily returns of 0.02%. Stocks and REITs were more volatile than corporate bonds and CMBS. Skewness was negative for corporate bonds and REITs while it was positive for the US stocks and CMBS. Kurtosis was particularly high for Mortgage REIT returns. All asset returns exhibited some significant serial correlation on daily basis, at the 10% level for the stock return, at the 5% level for the bond return, and at the 1% level for securitized real estate returns. In contrast, squared returns were strongly serial correlated across all five markets under consideration, suggesting the existence of ARCH effects on these markets. All instruments were also persistent, as shown in Panel B of Table 1. Table 2 shows the correlation matrix of asset returns as well as instruments. First, CMBS returns were negatively correlated with stock returns while CMBS returns had a high positive correlation with bond returns. Second, returns on both equity and mortgage REITs were positively correlated with stock returns and negatively correlated with bond returns. Next, the correlation between CMBS and equity REIT returns was negative while there was a positive correlation between CMBS and mortgage REIT returns. Finally, equity and mortgage REIT returns were negatively correlated. As for correlations among instruments, business cycle factors were positively correlated with stock market volatility but negatively correlated with the mortgage spread. Moreover, the mortgage spread had a negative correlation with stock market volatility.

Econometric Methodology The empirical methodology used in this study follows a two-pass procedure. First, following Cappiello et al. (2006), we estimate a multivariate VAR(1)- AG-DCCGJR-GARCH(1,1) model for various market index returns, and we obtain the conditional correlations for each pair of returns after controlling asymmetric volatilities and the influence of other markets.3 Second, similar to Engle and Rangel (2008), we examine the factors which cause conditional correlation by conducting time series regressions of estimated conditional correlation series on various instruments.

3 We choose VAR (1) because it is the optimal lag for all returns based on Schwarz Criterion (SC). The optimal lags based on Akaike Information Criterion (AIC) are typically somewhat longer. We also use these alternative lags to run regressions and find that results are similar.

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Table 1 Summary statistics

Panel A: Asset returns mean 0.008 .033 .007 0.088 .032 0.001 .036 52.931*** 37.055*** 0.060 0.068 28.496*** .007 20.004** 0.022 .196 0.268 .029 .489 33.331 4.740 3.131 0.023 0.052 0.015 1.664 1.078 0.325 0.304 0.733 1.130 0.050 2.214 0.014 16.283* Std Skew Kurt Lag1 Lag10 LB Q(10) for return LB Q(10) for squared return 657.081*** 139.060*** 613.589*** 827.944*** 463.965***

Period

Stat

Nobs

3/1/

S&P500

2321

1999

LBCB

2321

IG CMBS

2321

6/30/

FNER

2321

2008

FNMR

2321

Panel B: Instruments mean 0.938 0.290 1.371 0.024 0.038 0.981 0.930 0.982 0.968 0.980 0.975 0.973 1.043 20.184 6.587 0.574 0.425 0.538 1.444 0.252 0.214 0.775 0.994 0.977 0.953 0.971 0.955 0.895 Std Skew Kurt Lag1 Lag5 Lag10 LB Q(10) 22029.738*** 21722.543*** 21482.217*** 20199.610***

Period

Stat

Nobs

2/26/

DEF

2314

1999~

TERM

2278

6/30/

MGTB

2287

2008

VIX

2322

The table reports summary statistics for U.S. stock, corporate bond, CMBS and REITs daily returns as well as various instruments. Flrom Bloomberg, S&P500 denotes the log difference of S&P500 total return index (ticker: SPTR INDEX) while FNER and FNMR are the log differences of the FTSE NAREIT Equity REITs total return index (ticker: FNERTR INDEX) and mortgage REIT total return index (ticker: FNMRTR INDEX). From LehmanLive of Barclay Capital, formerly Lehman Brothers, LBCB and IG CMBS are the log difference of corporate bond and investment-grade CMBS total return indices. All instruments are from Bloomberg. DEF is the difference between Moody BAA and AAA bond yields. TERM is the difference between the 10-year and 3-month Treasury bill yields. MGTB is the difference between 30-year mortgage rate and Treasury bond yield. VIX is the Chicago Board Option Exchange S&P500 volatility index. All measures are in percentage. Nobs is the numbers of daily observations. LB Q(10) is the LjungBoxs Q (10) statistics with *, **, and *** denoting significance at 10%, 5%, and 1%, respectively. J. Yang

Asymmetric Correlation and Volatility Dynamics among Stock, Bond... Table 2 Correlation matrices S&P500 S&P500 LBCB CMBS FNER FNMR DEF TERM MGTB VIX 1.000 0.185 0.159 0.516 0.378 0.008 0.001 0.035 0.114 1.000 0.851 0.091 0.026 0.001 0.006 0.069 0.023 1.000 0.040 0.058 0.000 0.007 0.076 0.032 1.000 0.571 0.013 0.003 0.020 0.076 1.000 0.011 0.033 0.048 0.037 1.000 0.365 0.161 0.354 1.000 0.681 0.183 1.000 0.268 LBCB CMBS FNER FNMR DEF TERM MGTB

499

VIX

1.000

The table reports correlation matrices for U.S. stock, corporate bond, CMBS and REITs daily returns as well as various instruments. From Bloomberg, S&P500 denotes the log difference of S&P500 total return index (ticker: SPTR INDEX) while FNER and FNMR are the log differences of the FTSE NAREIT Equity REITs total return index (ticker: FNERTR INDEX) and mortgage REIT total return index (ticker: FNMRTR INDEX). From LehmanLive of Barclay Capital, formerly Lehman Brothers, LBCB and IG CMBS are the log difference of corporate bond and investment-grade CMBS total return indices. All instruments are from Bloomberg. DEF is the difference between Moody BAA and AAA bond yields. TERM is the difference between the 10-year and 3-month Treasury bill yields. MGTB is the difference between 30-year mortgage rate and Treasury bond yield. VIX is the Chicago Board Option Exchange S&P500 volatility index.

The Empirical Model In this section, we present a multivariate VAR-AG-DCC-GJR-GARCH(1,1) model for daily index returns of S&P500, US corporate bond, US investment-grade CMBS, US equity REITs, and US mortgage REITs. The model jointly estimates asymmetric volatilities and asymmetric correlations, which may improve the specification substantially. By comparison with a large body of the literature on asymmetric volatility, asymmetric correlation has received relatively less attention in the literature, which would be the focus of this study. As a popular alternative method, regime-switching models can also be used to analyze asymmetry in correlations. Nevertheless, regime-switching models typically assume a constant correlation matrix in each regime. By contrast, it is straightforward to derive continuous time series of time-varying conditional correlations through the AG-DCC-GARCH model for the further analysis. In general, the empirical model of this study can be written as: r t m t et ; rt rsp;t ; rcb;t ; rcm;t ; rer;t ; rmr;t ;
0

mt Ert jFt1 ;

et jFt1 $ N 0; H t ;

where rt is a 51 vector of index returns, t is a 51 vector of means conditioned on the information set Ft-1, et is a 51 vector of innovations, and Ht is the conditional variance-covariance matrix of rt (or equivalently et).

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For the conditional means, after the preliminary search on the VAR lag length, we consider the following VAR(1) specification: mit mi
5 X j1

lij rj;t1 ;

i 1 for stock; 2 for corporate bond; 3 for CMBS 4 for equity REIT ; 5 for mortgage REIT where is the constant mean and i is the autoregressive coefficient of the first lag. For the conditional variance-covariance matrix, Ht can be further decomposed into the diagonal matrix conditional standard deviation, Dt, and the conditional correlation matrix Rt: Ht Dt Rt Dt ; where Dt diaghit ;
1=2

3 4

hit wi ai "2 bi hi;t1 g i fmin"i;t1 ; 0g ; i;t1 Rt rij;t Et1 "i;t "j;t "t D1 et $ N0; 1 t

Note that in this model the conditional volatility hit is assumed to follow a univariate asymmetric GARCH(1,1) process as in Glosten et al. (1993). The p correlation estimator is rij;t qij;t = qii;t qjj;t and Rt can be written in terms of covariance matrix Qt qij;t as follows: Rt diagQt 1=2 Qt diagQt 1=2 5 As in Cappiello et al. (2006), the evolution of Qt is governed by asymmetric generalized DCC process: 6 Qt R A  "t1 "t1 R B  Qt1 R G  ht1 ht1 N ; 0 where R E "t "t , A, B and G are square(nxn), symmetric matrices, is Hadamard 0 product, ht min"t ; 0, and N E ht ht . We can choose a diagonal parameterization for A, B and G as follows A a C aC ; B bC bC ; G g C g C ; where C, C, and C are 51 vectors, so that for any W A  W diagfaC g W diagfaC g: 8
0 0 0 0 0

Hence for any i and j, we obtain the following expression to be used in the subsequent empirical analysis: qij;t rij ai;C aj;C "i;t1 "j;t1 rij bi;C bj;C qij;t1 rij g i;C g j;C hi;t1 hj;t1 N i;j 9

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Assuming normality, the log-likelihood function of the sample is given by XT 1X 0 l log2p logjDt Rt Dt j rt D1 R1 D1 rt L t t t t1 t 2 t 1X 0 0 0 log2p 2 lnjDt j rt D2 rt "t "t lnjRt j "t R1 "t : t t 2 t 10 Let the parameters in D be denoted q mi ; lij ; wi ; ai ; bi and the additional parameters in R be denoted f ai;C ; bi;C ; g i;C . The log likelihood function can be written as the sum of a volatility part and a correlation part: Lq; f LV q LC q; f; 11

where the volatility term is apparently the sum of individual GARCH likelihoods 1X 0 log2p 2 lnjDt j rt D2 rt ; 12 LV q t 2 t and the correlation term is: LC q; f 1X 0 0 "t "t lnjRt j "t R1 "t : t 2 t 13

Hence, the two-step estimation approach can be followed, as proposed in Engle (2002) and Cappiello et al. (2006), to maximize the likelihood function, which is to find q arg maxfLV qg; and then take this value as given in the second stage, Max LC q; f:
f ^ ^

14

15

In short, the model is designed to allow for two-stage estimation of the conditional covariance matrix. In the first stage, VAR(1) and univariate GARCH models are fit for each of the asset returns. In the second stage, asset returns, transformed by their estimated standard deviations, are used to estimate the parameters of the conditional correlations using the AG-DCC model. The second-stage analysis will proceed as follows. First, we estimate the DCC model as a benchmark. Next, we add one asymmetry parameter into the DCC model assuming the same impact of a negative systematic shock on all pairwise correlations. Having ensured the presence of asymmetric correlations, we further examine the more general AG-DCC model.4 To determine whether the models are well specified, a variety of diagnostic tests are also

Furthermore, a potential structural break point (July 31, 2007) can be incorporated in the DCC and AGDCC models. However, this addition has not significantly improved the goodness of fit, perhaps because the structural break might have been captured by the modeling of time variations in conditional correlations and their asymmetries.

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conducted on the standardized residuals from the VAR-AG-DCC-GJR-GARCH model. Time Series Regressions An important question is how daily conditional correlations change over macroeconomic conditions. Therefore, we estimate time series regressions of pairwise conditional correlations on factor loadings. First, we regress pairwise conditional correlations on each factor with its lag(s), bij;t cij r
Lk X l1

ckl fk;tl eij;t ; 8i 6 j; ij

16

where bij;t is the estimate of pairwise conditional correlations between asset returns i r and j derived as in Eqs. 6 and 7, and fk,t-l is macroeconomic factor k at the lag of period l with k =1 for default spread (DEF), 2 for term spread (TERM), 3 for mortgage spread (MGTB), 4 for stock market volatility (VIX). The purpose of regressions on a single instrument is to see how predictive power might vary from one factor to another. In general, if a factor is important for explaining a particular pairwise conditional correlation, the estimated coefficients ckl should be statistically significant. The optimal lag, Lk, can be ij selected by applying Akaike Information Criterion (AIC) and/or Schwarz Criterion (SC). Next, we also regress pairwise conditional correlations on multiple factors, bij;t cij r XX
k l

ckl fk;tl eij;t ; 8i 6 j; ij

17

where the notations have the same meanings as in Eq. 16. Also, the length of optimal lags is also the same as that based on Eq. 16. Furthermore, it is interesting to see whether the recent financial crisis plays any role in the correlation structure. Thus, we run regressions as in Eq. 17 for two subperiods: the pre-crisis period and the crisis period. The potential structural break point is set at July 31, 2007, which was the date when Bear Stearns liquidated two hedge funds that invested in various types of mortgage-backed securities.5 The standard Chow test (1960) is applied to test and confirm such a structural break in various correlations. Finally, as the regressions are conducted using estimates from the AG-DCC model, the estimates of conditional correlations are measured with noises. To deal with the errors-in-variables problem, coefficient estimates are adjusted for serial correlation (with 12 lags) and heteroskedasticity following Newey and West (1987).
5 Although there might be alternative dates which can be identified as potential structural break points and there are also techniques to search for unknown break points, the feedback from the industry suggests that the crisis began to have a substantial impact on various securities markets since July 31, 2007.

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Empirical Results Asymmetric Volatilities and Correlations Table 3 shows the parameter estimates of the mean and volatility models as well as the DCC models. In Panel A, CMBS returns can be weakly predicted by its own lag and lagged corporate bond returns. This shows the bond nature of CMBS and its close relationship with corporate bonds. Stock and equity REIT returns also to some extent predict future equity REIT returns. When compared with the results of CMBS, it is clear that the market treats equity REIT as an income stock as a REIT has to pay at 90% of its income as dividends. In contrast, the predictability of mortgage REIT returns is stronger: lagged corporate bond and CMBS returns are strong predictors of future mortgage REIT returns, in addition to predictive powers from equity and mortgage REIT returns. This further demonstrates that the market treats equity and mortgage REIT differently: an equity REIT is an income stock while a mortgage REIT is more similar to a bond. As shown in Panel B, almost all coefficients of GJR-GARCH models are positive and highly significant. The volatility for each asset return displays a highly persistent fashion since the sum of the estimated coefficients and in each variance equation is close to unity for all of the cases. Moreover, all asset returns exhibit asymmetric volatilities, indicating that volatilities increase after negative shocks for each return. Noteworthy, REITs, especially mortgage REITs, in comparison with other assets under consideration, show even stronger evidence of asymmetric volatilities because the magnitudes of the estimated coefficients are relatively bigger. To our knowledge, such evidence has not yet been reported in the literature. In the literature, two economic theories exist to explain asymmetric volatility: leverage effect and volatility feedback effect (time-varying risk premiums). Stronger evidence of asymmetric volatility for REITs can be explained by the leverage effect because a REIT typically employs high leverage. In order to qualify as a REIT, the company must distribute at least 90% of its annual taxable income as dividends to its shareholders and invest at least 75% of its total assets in real estate equity (or debt). Retaining little earnings and being capital intensive, REITs have to borrow to grow. Thus, it is not uncommon for a REIT to employ high leverage. Typically, mortgage REITs tend to be even more highly levered with debt than equity REITs.6 The high leverage can make earning streams and dividend payments, and thus REITs returns, much more volatile than other assets. The time series profile of the five assets conditional volatilities over the full period and the crisis period is shown in Panel A of Table 5. The means of these volatilities are close to their unconditional counterparts, which suggest the adequacy of volatility modeling. Among them, equities, especially mortgage REITs, are much more volatile than fixed income securities. After the crisis started, the volatilities increased for all markets. Consistent with the use of GARCH models, the volatilities were strongly serially correlated in both the full sample and the crisis period.
6

According to Chan et al. (2003), during the period from 1990 to 2000, the total debt to total capital ratio is 48% for equity REITs and 65% for mortgage REITs and the total debt to market cap ratio is 42% for equity REITs and 52% for mortgage REITs.

504

Table 3 Estimation results of the mean and volatility as well as DCC models

Panel A: Estimation results of VAR(1) model lagged S&P500 0.051*** (3.059) 0.026*** 0.034 (0.843) 0.129*** (4.573) 0.056 (0.524) 0.289*** (2.577) (4.611) 0.007 0.078*** (2.861) 0.020 (0.177) 0.370*** (5.469) (1.312) 0.032** (2.092) 0.033 (1.420) (1.355) 0.055 (0.541) (0.581) 0.069 0.077 corporate bond CMBS 0.019 (1.418) 0.009*** (3.102) 0.001 (0.170) 0.155*** (5.872) 0.076*** (2.597) lagged lagged lagged Equity REIT lagged Mortgage REIT 0.010 (1.005) 0.003 (0.619) 0.002 (0.410) 0.004 (0.399) 0.134*** (6.003)

Return i

constant

S&P

0.003

500

(0.186)

Corporate

0.022***

Bond

(3.239)

IG

0.022***

CMBS

(5.566)

Equity

0.038***

REIT

(3.018)

Mortgage

0.053**

REIT

(2.525)

Panel B: Estimation results of GJR-GARCH models

i

Return i
i i

0.034*** (4.192)

S&P

0.011***

0.936*** (103.626)

0.075*** (9.331)

J. Yang

500

(3.326)

Corporate (0.642) 0.015*** (3.178) 0.038*** (2.659) 0.072*** (4.182) (41.248) (7.303) 0.856*** 0.126*** (49.474) (7.167) 0.910*** 0.104*** (158.189) (14.143) 0.932*** 0.069*** (57.191) (8.702)

0.003**

0.004

0.940***

0.054***

Bond

(2.553)

IG

0.003***

CMBS

(10.558)

Equity

0.020***

REIT

(3.088)

Mortgage

0.084***

REIT

(4.900)

Panel C: Estimation result of DCC models

i,C

Model
i,C i,C

0.983*** 13062.171 0.006*** 13056.928 (2.916) rit mi li rit1 eit ; et $ N 0; Ht ; Ht Dt Rt Dt ; (7402.036) 0.982*** (567.172)

Log likelihood

LR statistics

DCC

0.016***

(131.175)

Asymmetric DCC

0.014***

10.486***

(9.634)

The mean and volatility models are as follows:

1=2

Asymmetric Correlation and Volatility Dynamics among Stock, Bond...

Dt diaghit ; hit wi ai "2 bi hi;t1 g i fmin"i;t1 ; 0g2 ; "t D1 et i;t1

where subscripts i {1,2,3,4,5} with 1 for the S&P500 return, 2 for corporate bond return, 3 for investment-grade CMBS return, 4 for equity REIT return, and 5 for mortgage REIT return respectively.

The t-statistics are reported in parenthesis below the coefficients with *, **, and *** denoting significance at 10%, 5%, and 1%, respectively.

505

506

J. Yang

In Panel C of Table 3, the asymmetric DCC model fits better than the benchmark DCC model without asymmetry, based on estimated log-likelihood functions and the resulting likelihood ratio test. Moreover, the estimated coefficients C is significantly positive, suggesting significantly higher correlation across assets when their returns are negative. However, such a model specification cannot distinguish pairwise correlations across different types of assets. To address this issue, we will turn to the more general AG-DCC model. Table 4 reports the estimation results of the AG-DCC model. The estimated loglikelihood values and the resulting likelihood ratio statistics suggest that the AGDCC model fits significantly better than the asymmetric DCC model, underscoring the importance of more flexible modeling of conditional correlation dynamics.7 Most parameters are significantly positive. The possible exceptions might be that the estimated coefficients C for corporate bond or CMBS return are negative (although not significant), which implies that responding to corporate bond (or CMBS) and another assets (stock, equity REITs, or mortgage REITs) negative returns, their correlations tend to be lower or at least not higher. Such an asymmetric correlation pattern implies that corporate bonds and CMBS may provide diversification benefits for stocks and REITs. Hence, a higher weight of corporate bonds and CMBS in a portfolio might produce better diversification. In contrast, correlations between stocks and (either equity or mortgage) REITs are significantly higher when both asset returns are negative. The evidence strongly suggests that REITs have less hedging potential during the stock market downturn when such a hedging strategy may be most needed. The finding is consistent with Chandrashekaran (1999) who found that covariability of REIT returns with the general stock market is higher when the REIT index is falling and also Glascock et al. (2000) who found that REITs behave more like small-cap stocks than bonds. More evidence of asymmetric correlations is summarized in Matrix G, as shown in Panel D. Panels B and C also indicate that the shocks to correlations are typically highly persistent. It is important to investigate why the correlations are asymmetric and why asymmetric correlations have different patterns. On one hand, the cross-market hedging effect can explain the asymmetric correlation pattern between corporate bond (or CMBS) and stock (or REITs). Note that REITs are included into board stock indexes in October 2001 and CMBS is accepted as an important sector within broad bond markets as demonstrated by its inclusion in two of the important bond indices, the Lehman US Aggregate Bond Index in January 1999 and the Merrill Lynch US Bond Index in 2004. Stocks and bonds are two major asset classes, which tend to move in the opposite directions and offer cross-hedging opportunities. On the other hand, the asymmetric correlation between stock and REITs can be explained
7 A variety of diagnostic tests are conducted on the standardized residuals from the VAR-AG-DCC-GJRGARCH model. Although the skewness and kurtosis are still significantly different from zero, the values of kurtosis are much smaller than those of asset returns. Ljung-Box Q tests show that autocorrelations of the standardized residuals are insignificant at the 1% level and that autocorrelations of the squared standardized residuals are either insignificant or at least much weaker than those of asset returns. LM tests suggest no remaining ARCH effects in the standardized residuals for general financial markets but not for securitized real estate markets. Overall, the results (available on request) suggest that the estimation of the VAR-AG-DCC-GJR-GARCH model leads to a better fit of the data but still leaves room for further improvement.

Asymmetric Correlation and Volatility Dynamics among Stock, Bond... Table 4 Estimation results of AG-DCC models
Panel A: Parameters i 1 2 3 4 5
i,C

507

i,C

i,C

Log-likelihood 12967.263

LR statistics 179.33***

0.111*** (8.600) 0.161*** (16.946) 0.145*** (17.956) 0.135*** (6.128) 0.119*** (5.511)

0.988*** (410.940) 0.986*** (618.712) 0.989*** (824.118) 0.974*** (147.660) 0.973*** (142.842)

0.152*** (8.563) 0.033 (1.271) 0.012 (0.461) 0.180*** (7.765) 0.214*** (6.722)

Panel B: Matrix A 0.012 0.019 0.016 0.015 0.013 Panel C: Matrix B 0.976 0.975 0.978 0.963 0.962 Panel D: Matrix G 0.023 0.005 0.002 0.027 0.033 0.005 0.001 0.000 0.006 0.007 0.002 0.000 0.000 0.002 0.002 0.027 0.005 0.002 0.032 0.038 0.032 0.006 0.002 0.038 0.046 0.975 0.973 0.976 0.961 0.960 0.978 0.976 0.979 0.964 0.963 0.963 0.961 0.964 0.949 0.948 0.962 0.960 0.963 0.948 0.948 0.018 0.026 0.023 0.022 0.019 0.016 0.023 0.021 0.020 0.017 0.015 0.022 0.020 0.018 0.016 0.013 0.019 0.017 0.016 0.014

The correlation estimator R t can be written in terms of covariance matrix Qt qij;t as 0 Rt diagQt 1=2 Qt diagQt 1=2 . The evolution of t is given by: Qt R A  "t1 "t1 R 0Q 0 B  Qt1 R G  ht1 ht1 N , where R E "t "t , A, B 0 and G are square (55), symmetric matrices, is Hadamard product, ht min"t ; 0, and N E ht ht . A diagonal parameterization is chosen for A, B and G: A aC aC ; B bC bC ; G hC hC , where C, C, and C are 51 vectors, so that for any i and j, qij;t rij ai;C aj;C "i;t1 "j;t1 rij bi;C bj;C qij;t1 rij g i;C g j;C hi;t1 hj;t1 N i;j .
0 0 0

In Panel A, the t-statistics are reported in parenthesis below the coefficients. *, **, and *** denoting significance at 10%, 5%, and 1% respectively. The LR statistic is against the asymmetric DCC model.

by the risk premium effect. As the REIT market is (to a large extent) integrated with the general stock market, a negative systematic shock will increase volatility and induce risk premium increases for both markets, causing price drop and the correlation increase in stock and REIT returns. To further explore the asymmetry in

508

J. Yang

correlation, we will study correlation dynamics and its driving forces in the following two subsections. Correlation Dynamics We can obtain the conditional correlation series based on Eqs. 5 and 6. Figure 1 plots the conditional correlations between CMBS and general financial markets. The correlation between CMBS and stock returns swings from 60% to 30%, and is mostly negative. It is also clear that the correlation started to decrease before the stock market reached the peaks (September 2000, October 2007) and kept going down as the stock market declined, which is quite similar to the correlation pattern between CMBS and equity REITs and between corporate bond and the general stock market (to be discussed below). This demonstrates the diversification potential when stocks and CMBS are combined in an investment portfolio. The correlation between CMBS and corporate bond returns stayed at a high level before it dropped sharply when the financial crisis began in August 2007. The high correlation is not surprising because both CMBS and corporate bonds are debt, and by design, the investment-grade CMBS index mirrors the investment-grade corporate bond index. What is interesting is whether the recent financial crisis plays any role in the correlation breakdown, which will be tested in the next subsection. Figure 2 plots the conditional correlations between equity REITs and general financial markets. The dynamic correlation between equity REIT and stock returns supports and adds to our understanding of the general patterns found by the previous studies (e.g., Cotter and Stevenson 2006). Despite the substantial variation over time, we also can see a fairly steady upward trend from 1999 to 2008 in the correlation, which reached as high as 80% in mid 2008. The plausible explanations might go as follows. First, through the REIT Modernization Act (RMA), taxable REIT subsidiaries were created in 2001 to expand the business activities of REITs. Changes in the regulations have forced REITs to become more like operating companies. Second, the increased size of the largest REITs, along with an Internal Revenue Service ruling to the effect that REITs are active businesses, led to the decision in October 2001 to include REITs within board stock market indices. Indeed, as shown in the graph, the REIT-stock correlation jumped very drastically in September and October 2001. The increased correlation suggests that the diversification potential of equity REITs has been weakening. Furthermore, the increased correlation between equity REIT and stock returns around March 2003, December 2007 and June 2008 seems to be consistent with asymmetric correlations between equity portfolios during extreme downside moves due to the risk premium effect. By comparison, the correlation between equity REIT and corporate bond returns fluctuates around zero. The conditional correlations between mortgage REITs and general financial markets show similar patterns, as plotted in Fig. 3. It should also be noted that the conditional correlations between mortgage REIT and stock returns did not significantly increase in October 2001, but did increase later in 20022003. It might be because that the REIT industry in recent years has been largely dominated by equity REITs, not only in number but also in market capitalization. Therefore, REITs included in the stock indexes are mostly equity REITs instead of mortgage REITs.

Asymmetric Correlation and Volatility Dynamics among Stock, Bond...

Conditional Correlation between S&P500 and IG CMBS Returns
0.4

509

0.3

0.2

0.1

Correlation

-0.1

-0.2

-0.3

-0.4

-0.5

-0.6 M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J99 99 99 99 00 00 00 00 01 01 01 01 02 02 02 02 03 03 03 03 04 04 04 04 05 05 05 05 06 06 06 06 07 07 07 07 08 08

Date

Conditional Correlation between Corporate Bond and IG CMBS Returns

1

0.8

Correlation
0.6 0.4 M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J99 99 99 99 00 00 00 00 01 01 01 01 02 02 02 02 03 03 03 03 04 04 04 04 05 05 05 05 06 06 06 06 07 07 07 07 08 08

Date

Fig. 1 Conditional correlations between CMBS and general financial markets

With the high-tech bubble burst, value investing again became popular since 2002 2003. Mortgage REITs were quintessential values. The main attractions from an investor perspective are the relatively high dividend yields offered by mortgage REITs, ranging from 7% to 10% compared with those of equity REITs, which are typically close to 5%. Figure 4 plots the conditional correlations between REITs and CMBS. Two types of REITs have quite similar correlation dynamics with CMBS, which fluctuates around zero. Similar to the plot of the estimated correlation between stock and corporate bond markets (available on request), the correlation between equity REITs and CMBS trended down and even turned to be negative when the stock market plunged (e.g., around March 2003, December 2007, and June 2008). The new

510
Conditional Correlation between S&P500 and Equity REIT Returns
0.9

J. Yang

0.8

0.7

Correlation

0.6

0.5

0.4

0.3

0.2

0.1 M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J99 99 99 99 00 00 00 00 01 01 01 01 02 02 02 02 03 03 03 03 04 04 04 04 05 05 05 05 06 06 06 06 07 07 07 07 08 08

Date

Conditional Correlation between Corporate Bond and Equity REIT Returns

0.3

0.2

0.1

Correlation

-0.1

-0.2

-0.3

-0.4 M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J99 99 99 99 00 00 00 00 01 01 01 01 02 02 02 02 03 03 03 03 04 04 04 04 05 05 05 05 06 06 06 06 07 07 07 07 08 08

Date

Fig. 2 Conditional correlations between equity REIT and general financial markets

evidence here implies that the diversification potential within the securitized real estate markets parallels the stock-corporate bond correlation pattern since REITs are public commercial real estate equity while CMBS are public commercial real estate debt. Noteworthy, the time variation pattern of the correlations for these two pairs (equity REIT-CMBS and S&P 500-corporate bond) is quite similar to that between stocks and Treasury bonds, as documented in the literature (Andersen et al. 2007; Yang et al. 2009). In particular, as observed in Andersen et al. (2007, p.257), during the expansion, the stock-(Treasury) bond correlation tends to be positive, whereas during the contraction it tends to be negative. A possible explanation is that the cash flow effect dominates during contractions while the discount rate effect dominates in expansions (due to central bank policy), producing positive or higher stock-bond

Asymmetric Correlation and Volatility Dynamics among Stock, Bond...

Conditional Correlation Between S&P500 and Mortgage REIT Returns
0.8

511

0.7

0.6

Correlation

0.5

0.4

0.3

0.2

0.1

0 M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J99 99 99 99 00 00 00 00 01 01 01 01 02 02 02 02 03 03 03 03 04 04 04 04 05 05 05 05 06 06 06 06 07 07 07 07 08 08

Date

Conditional Correlation between Corporate Bond and Mortgage REIT Returns

0.3

0.2

0.1

Correlation

-0.1

-0.2

-0.3 M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J99 99 99 99 00 00 00 00 01 01 01 01 02 02 02 02 03 03 03 03 04 04 04 04 05 05 05 05 06 06 06 06 07 07 07 07 08 08

Date

Fig. 3 Conditional correlations between mortgage REIT and general financial markets

return correlations during expansions and negative or lower in contractions. Using the data in the past 150 years, Yang et al. (2009) provide further supportive evidence that higher (lower) stock(Treasury) bond correlations tend to follow higher (lower) short rates, which most likely occurs in expansions (recessions). Finally, equity and mortgage REIT returns are always positively correlated since they are more or less in the same asset class. Moreover, their correlation was typically below 50% before mid-2002 and above 50% after that. The presence of structural change may be due to the past failure of mortgage REITs until early 2000s. It also carries implications that diversification benefits within the REIT sector have largely diminished. In sum, we have characterized the dynamics of pairwise correlations among CMBS, REITs, and general financial markets. To provide more information concisely about the correlation dynamics, the summary statistics for the derived

512
Conditional Correlation between IG CMBS and Equity REIT Returns
0.3

J. Yang

0.2

0.1

Correlation

-0.1

-0.2

-0.3

-0.4 M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J99 99 99 99 00 00 00 00 01 01 01 01 02 02 02 02 03 03 03 03 04 04 04 04 05 05 05 05 06 06 06 06 07 07 07 07 08 08

Date

Conditional Correlation between IG CMBS and Mortgage REIT Returns

0.3

0.2

0.1

Correlation

-0.1

-0.2

-0.3 M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J- S- D- M- J99 99 99 99 00 00 00 00 01 01 01 01 02 02 02 02 03 03 03 03 04 04 04 04 05 05 05 05 06 06 06 06 07 07 07 07 08 08

Date

Fig. 4 Conditional correlations between CMBS and REIT markets

conditional correlation series are presented in Panel B of Table 5. On average, four pairs of correlations are negative: stock and corporate bond returns, CMBS and stock returns, equity REIT and corporate bond returns, as well as equity REIT and CMBS returns. Thus, the assets in each pair are a good hedge to each other. We also compare the average of each conditional correlation series to its unconditional counterpart. Except for the pair of mortgage REITs and CMBS, the signs of other pairwise conditional and unconditional correlations are the same and the magnitudes are close.8 Additional analyses are reported in Panel B.
Noteworthy, there are far fewer mortgage REITs forming the index than equity REITs. Furthermore, components of the mortgage REIT index are very heterogeneous: Some are mortgage lenders; some are MBS/CMBS investors. Such data limitations could lead to less robustness of our finding regarding the mortgage REIT index.
8

Asymmetric Correlation and Volatility Dynamics among Stock, Bond...

Conditional Correlation between Equity REIT and Mortgage REIT Returns
0.9

513

0.8

0.7

0.6

Correlation

0.5

0.4

0.3

0.2

0.1
M /9 9 J/ 99 S/ 99 D /9 9 M /0 0 J/ 00 S/ 00 D /0 0 M /0 1 J/ 01 S/ 01 D /0 1 M /0 2 J/ 02 S/ 02 D /0 2 M /0 3 J/ 03 S/ 03 D /0 3 M /0 4 J/ 04 S/ 04 D /0 4 M /0 5 J/ 05 S/ 05 D /0 5 M /0 6 J/ 06 S/ 06 D /0 6 M /0 7 J/ 07 S/ 07 D /0 7 M /0 8 J/ 08

Fig. 4 (continued)

Date

Autocorrelations and Ljung-Box Q tests show that all conditional correlations are quite persistent. After controlling for 3 lags, the regressions of correlations on a time trend variable suggest that only three correlation series display significant trending behavior: stock-equity REIT, stock-mortgage REIT, and equity RETmortgage REIT.9 Furthermore, Chow tests suggest a structural break in all correlations caused by the recent financial crisis since July 31, 2007. Driving Forces of Correlations: Further Analysis Table 6 shows simple regression results of conditional correlations on the first lag of various macroeconomic variables, with the robust standard error based on Newey and West (1987) as discussed above.10 We focus on the first lag because it is the optimal lag for almost all correlations based on Schwarz Criterion (SC). Given a relatively large sample size with 2320 observations, we should focus on the 1% significance level as other conventional (5% or 10%) significance levels are probably inappropriate. First, all regression coefficients of default spread are
9 The linear time-trend coefficients for the three significant cases are 4.9106 at the maximum. By multiplying the sample size (2320), the increase of these correlations over time is no more than 0.01 over the study period, which is small. It suggests that the trending behavior is not a major driving force of conditional correlation movement, particularly compared to macroeconomic variables under consideration. 10 One might also consider using the system estimation methods such as SUR and GMM. Although SUR in general is more efficient, its efficiency would be the same as separate estimation of individual OLS regressions in the case that all regressions in the system have identical independent variables. Furthermore, as our OLS regressions are also conducted following Newey and Wests (1987), the results probably would remain qualitatively unchanged compared with applying GMM to a system of linear regressions. Finally, we also conduct unit root tests on the residuals from these regressions. While the variables used in the regressions are persistent, the augmented Dickey-Fuller tests reject the null hypothesis of a unit root for all regression residuals, which suggests the stationarity of these regression residuals and thus nonexistence of the spurious regression problem.

514

Table 5 Summary of volatilities and conditional correlations

Panel A: Conditional volatilities Mean 1.258 0.092 0.104 1.147 2.707 1.694 0.126 0.197 3.755 8.119 9.443 0.897 0.589 0.300 4.469 0.915 0.742 0.674 0.254 0.969 0.843 0.722 0.158 0.960 0.856 0.748 1.687 0.928 0.741 0.570 2.769 0.907 0.642 0.441 1.162 0.972 0.891 0.824 18462.101*** 10052.433*** 1295.756*** 1705.652*** 1648.430*** 1352.836*** 860.597*** 0.106 0.974 0.873 0.775 17542.697*** 0.092 0.973 0.880 0.772 17715.956*** 1.277 0.979 0.894 0.812 18501.836*** unconditional variance Lag 1 Lag 5 Lag 10 LB Q(10)

Volatility

Full Sample

S&P500

Corporate bond

IG CMBS

Equity REIT

Mortgage REIT

Crisis period sample

S&P500

Corporate bond

IG CMBS

Equity REIT

Mortgage REIT

Panel B: Conditional correlations Unconditional Correlation 0.159 0.851 0.516 0.091 0.378 0.026 0.058 0.571 0.040 0.185 0.995 0.987 0.989 0.983 0.981 0.908 0.918 0.951 0.932 0.978 0.990 0.950 0.987 0.929 0.985 0.922 0.996 0.979 0.954 0.844 0.851 0.900 0.822 0.837 0.911 0.856 0.939 0.995 0.975 0.948 Lag 1 Lag 5 Lag 10 LB Q(10) 22005.378*** 22173.458*** 19502.461*** 19749.489*** 20798.566*** 18918.611*** 19311.822*** 20918.523*** 19879.081*** 21791.748*** Time trend NO NO YES NO YES NO NO YES NO NO Structural break YES YES YES YES YES YES YES YES YES YES

Mean

sp,cm

0.129

cb,cm

0.911

sp,er

0.535

cb,er

0.045

sp,mr

0.444

cb,mr

0.015

cm,mr

0.022

mr,er

0.538

cm,er

0.039

sp,cb

0.122

J. Yang

The table reports conditional volatilities and correlations for U.S. stock, corporate bond, CMBS and REITs daily returns using the AG-DCC model. ij,t is the estimate of pairwise conditional correlations between asset returns i and j derived as in Eqs. 6 and 7, where the subscripts, sp, cb, cm, er, and mr, denote S&P500, corporate bond, CMBS, equity REITs, and mortgage REITs respectively. LB Q(10) is the Ljung-Boxs Q (10) statistics with *, **, *** denoting significance at 10%, 5%, and 1% respectively.

Asymmetric Correlation and Volatility Dynamics among Stock, Bond... Table 6 Estimation results of the OLS regressions with a single instrument
DEFt-1 sp,cm cb,cm sp,er cb,er sp,mr sp,mr cm,er cm,mr mr,er sp,cb 0.433*** 0.164*** 0.203*** 0.335*** 0.149*** 0.221*** 0.284*** 0.187*** 0.129*** 0.508*** R2 26.4% 18.5% 11.2% 33.0% 3.5% 27.1% 26.6% 18.9% 2.9% 40.6% TERMt-1 0.058*** 0.008*** 0.014** 0.011* 0.008 0.006 0.018*** 0.008* 0.001 0.043*** R2 21.8% 1.8% 2.3% 1.5% 0.4% 0.8% 5% 1.7% 0.0% 13.3% MGTBt-1 0.158*** 0.082*** 0.045* 0.009 0.125*** 0.017 0.032* 0.007 0.165*** 0.117*** R2 13.9% 17.9% 2.1% 0.4% 9.9% 0.6% 1.3% 0.0% 19.2% 8.4% VIXt-1 0.012*** 0.006*** 0.001 0.008*** 0.010*** 0.006*** 0.009*** 0.007*** 0.009*** 0.011***

515

R2 19.9% 24.5% 0.4% 19.4% 15.1% 17.4% 26.1% 24.2% 16.1% 19.3%

where bij;t is the estimate of pairwise conditional correlations between asset returns i and j derived as in r Eqs. 6 and 7, and fk,t-1 is macroeconomic factor k at the first lag. The subscripts, sp, cb, cm, er, and mr, denote S&P500, corporate bond, CMBS, equity REITs, and mortgage REITs respectively. The estimates of cij in each simple regression are reported with *, **, *** denoting significance at 10%, 5%, and 1% respectively. R-squares are also reported for each simple regression.

This table summarizes estimates of the following OLS regressions with a single instrument (and with Newey and Wests (1987) robust standard error): bij;t cij ck fk;t1 eij;t ; 8i 6 j r ij

statistically significant at the 1% significance level. Among them, higher correlations of stock-equity REIT, stock-mortgage REIT, and equity REIT-mortgage REIT returns tend to follow higher default spread. As predicted by the risk premium explanation discussed earlier, these three pairwise correlations between (common or real estate) equities should (and do) increase when business conditions become poor. By contrast, other pairwise conditional correlations tend to be lower following higher default spread, which is consistent with the earlier finding based on the cross-market hedging effect. It carries the asset allocation implication that investors should diversify away from equities when the default spread is higher during the market downturn. Second, most slope estimates of term spread are also negative. However, the evidence is a bit weaker. Only 4 out of 10 coefficients are significant at the 1% significance level. The reason might be that term spreads only capture the short term aspect of business conditions (Fama and French 1989). Third, as for the mortgage spread, there are no clear patterns on how it predicts various conditional correlations, although it is significant in predicting correlations between CMBS and stock or bond markets, between mortgage REITs and equity REITs or stocks, and somewhat surprisingly between stock and bond returns. The result should also be interpreted with some caution because the mortgage spread captures some but not all information related to REITs and CMBS. Finally, the stock market volatility index is a strong predictor of various correlations. All slope coefficients are negative and mostly significant at the 1% significance level. Correlations are predicted to decrease when the stock market becomes more volatile. A high VIX is not necessarily always bearish for stocks but implies significant uncertainty that the market will move sharply, whether downward or upward. A significant component of the recent jump in VIX is due to investors declining appetite for risk and their attempt to diversify away from risky assets to safe assets, such as cash or Treasury bills. Thus, the explanation points to the less correlated assets due to behaviors of flight to quality.

516

Table 7 Estimation results of the OLS regressions with multiple instruments DEFt-1 TERMt-1 MGTBt-1 VIXt-1 Adj-R2 Chow tests F-statistics

Constant

Panel A: The whole sample (3/1/1999-6/30/2008) 0.239*** 0.169*** 0.298*** 0.067*** 0.028*** 0.007*** 0.007*** 0.004*** 0.010*** 0.006*** 0.005*** 0.011*** 0.061*** 0.010* 0.022*** 0.012** 0.059*** 0.025*** 0.186*** 0.257*** 0.036** 0.104*** 0.005 0.211*** 0.077*** 0.177*** 0.304*** 0.303*** 0.203*** 0.207*** 0.137*** 0.247*** 0.390*** 0.001 0.005 0.069*** 0.003*** 49.3% 35.8% 44.3% 38.7% 35.5% 45.4% 33.8% 44.1% 56.6% 0.008 0.014*** 0.212*** 52.8% 32.92*** 811.53*** 83.96*** 97.29*** 42.81*** 93.87*** 49.30*** 58.53*** 44.27*** 79.77***

sp,cm

0.141***

cb,cm

1.204***

sp,er

0.481***

cb,er

0.284***

sp,mr

0.585***

cb,mr

0.272***

cm,er

0.218***

cm,mr

0.232***

mr,er

0.745***

sp,cb

0.254***

Panel B: The sample before the crisis (3/1/1999-7/31/2007) 0.315*** 0.018 0.200*** 0.057*** 0.015*** 0.050*** 0.004 0.231*** 0.204*** 0.163*** 0.000 0.004 0.184*** 0.040*** 0.188*** 0.072*** 0.216*** 0.016 0.013*** 0.004*** 0.001 0.007*** 0.007*** 0.003*** 56.1% 64.7% 30.4% 40.5% 39.4% 30.4% J. Yang

sp,cm

0.223***

cb,cm

1.072***

sp,er

0.561***

cb,er

0.238***

sp,mr

0.664***

cb,mr

0.258***

Table 7 (continued) DEFt-1 0.244*** 0.175*** 0.162*** 0.047*** 0.010 0.011*** 0.180*** 56.6% 0.254*** 0.006*** 0.295*** 46.5% 0.002 0.005*** 0.002 37.3% 0.018*** 0.009*** 0.086*** 49.7% TERMt-1 MGTBt-1 VIXt-1 Adj-R2 Chow tests F-statistics

Constant

cm,er

0.266***

cm,mr

0.258***

mr,er

0.811***

sp,cb

0.192***

Panel C: The sample during the crisis (8/1/2007-6/30/2008) 0.271*** 0.189* 0.055 0.025* 0.123*** 0.221*** 0.005 0.004 0.003 0.010*** 0.002 0.001 0.001 0.016 0.008 0.121 0.043 0.019 57.5% 40.9% 53.5% 21.6% 63.3% 9.5% 0.034* 0.105*** 0.126*** 0.109*** 0.075** 0.078** 0.009** 45.6% 0.003 0.439*** 0.156*** 0.353*** 0.317*** 0.223** 0.221** 0.415*** 0.164*** 19.6% 0.057** 0.043 0.004 63.6% 0.112*** 0.086 0.002 48.0%

sp,cm

0.004

cb,cm

1.100***

sp,er

0.508***

cb,er

0.346***

sp,mr

0.488***

cb,mr

0.250***

cm,er

0.041

cm,mr

0.108

mr,er

0.473***

Asymmetric Correlation and Volatility Dynamics among Stock, Bond...

sp,cb

0.106

where bij;t is the estimate of pairwise conditional correlations between asset returns i and j derived as in Eqs. 6 and 7, and fk,t-1 is macroeconomic factor k at the first lag. The r subscripts, sp, cb, cm, er, and mr, denote S&P500, corporate bond, CMBS, equity REITs, and mortgage REITs respectively. The estimates of ck and F-statistics for ij Chow tests are reported with *, **, *** denoting significance at 10%, 5%, and 1% respectively. Adjusted R-squares are also reported.

This P table summarizes estimates of the following OLS regressions with multiple instruments (and with Newey and Wests (1987) robust standard error): bij;t r cij ck fk;t1 eij;t ; 8i 6 j ij

517

518

J. Yang

Next, multiple regression results of conditional correlations on the first lags of various macroeconomic variables are shown in Table 7, again with Newey and Wests (1987) robust standard error. In Panel A, combinations of business cycle, volatility, and real estate sector-specific factors can explain substantial portions of various correlations with adjusted R-squares varying from 33.8% to 56.6%. Again, all regression coefficients of the default spread are statistically significant at less than the 1% level. Moreover, the patterns are generally the same as those based on simple regressions. After controlling other factors, higher correlations between equities tend to follow a higher default spread while other correlations tend to be lower, if the default spread is higher. The above different predictive patterns can be attributed to the risk premium explanation and the cross-market hedging effect, respectively. Meanwhile, the predictive patterns of the stock market volatility index are also robust. Except for one insignificant case, all slope estimates are significantly negative and the underlying economic forces could be behaviors of flight to quality. In contrast, the results for term and mortgage spreads are not as clearcut as those for the default spread and the stock market volatility index. Noteworthy, the default spread and the stock market volatility index have not only statistically significant, but also economically significant, explanatory power for various correlations. After controlling for other factors, the three positive coefficient estimates on default spread are 0.298, 0.303, and 0.247 respectively in Panel A of Table 7. Thus, by multiplying its mean (0.981 in Panel B of Table 5), the default spread on average induces 29.5%, 29.7%, and 24.2% increase in three pairwise correlations between equities. Also, the negative coefficient estimates on default spread range from 0.137 to 0.390, implying that the default spread on average leads to significant decrease in other correlations, varying from 13.4% to 38.3%. As for the stock market volatility index, the significant coefficients in the multiple regressions are in the range of 0.003 and 0.014. Thus, by multiplying its mean (20.184 in Panel B of Table 5), the stock market volatility index on average causes correlations to decrease, which are varying from 6.1% to 28.3%. Overall, among the macroeconomic factors that affect correlations, default spread and stock market volatility play an important role in driving correlations among CMBS, REITs, and general financial markets. Furthermore, F-statistics of Chow test are significant at less than the 1% level for all correlations. This indicates a structural break in the correlations caused by the recent financial crisis since July 31, 2007. Panels B and C of Table 7 show multiple regression results for the pre-crisis period and the crisis period respectively. The results for the pre-crisis period are consistent with those based on the whole sample. However, there are some interesting new findings during the crisis period. Except for two cases, the VIX index becomes insignificant in predicting correlations during the crisis period. More noticeable difference is that term spread becomes a strong predictor of various correlations between equity and fixed income securities during the crisis period. Following a lower term spread, correlations between stock (or REITs) and bond (or CMBS) tend to be lower. According to the expectation theory, flattening of the yield curve indicates that market participants expect short-term interest rates to fall and economic conditions to deteriorate in the future. This is true for the crisis period because the Fed continued to cut the policy rate down to a historically low level. As discussed in Yang et al. (2009), in such a situation, the cash flow effect dominates the

Asymmetric Correlation and Volatility Dynamics among Stock, Bond...

519

discount rate effect, which tends to drive down the correlations between equity and fixed income securities. Further research is certainly needed to look at driving forces of correlations during the crisis period in more depth.

Conclusions This study explores asymmetries in time-varying volatilities and particularly timevarying correlations among CMBS, (both equity and mortgage) REITs, stocks, and corporate bonds from 1999 to 2008. For the first time, we document evidence for asymmetric volatilities and correlations in CMBS and REITs. While all asset returns exhibit asymmetric volatilities, with high leverages, REIT returns exhibit stronger asymmetric volatilities than stock, bond, and CMBS returns. Moreover, REIT and stock returns show significant asymmetry in their conditional correlation, which implies less hedging potential of REITs to stock market investors during the market downturn. By contrast, corporate bond and CMBS may provide better diversification benefits for stocks and REITs. We also characterize the dynamics of pairwise conditional correlations between these asset classes (with allowance for the other assets under consideration) and find that the assets in each of four pairs, stock-corporate bonds, CMBS-stock, equity REIT-corporate bonds, and equity REIT-CMBS, are a good hedge to each other. Furthermore, we demonstrate (statistically and economically) significant predictability of time-varying correlations particularly by a key macroeconomic condition indicator (the default spread) and stock market volatility. Higher correlations between equities (i.e., stock and REITs) tend to follow a higher default spread, which is consistent with asymmetric correlations of equity portfolios during bad times due to the risk premium effect. By contrast, other correlations between equities and debts, including those of equity REIT-CMBS and stock-corporate bonds, tend to be lower if the default spread is higher, perhaps due to the cross-market hedging effect. The finding also suggests that the time variation pattern of the stock(Treasury) bond correlation documented in the literature may largely apply to other types of equity-debt correlations such as stock-corporate bonds and equity REITCMBS. The correlations under consideration are generally predicted to decrease when the stock market becomes more volatile. The mortgage spread, a proxy for the sector specific factor, also plays a significant role in driving some but not all conditional correlations related to REITs or CMBS. Moreover, there is a significant structural break in the correlations caused by the recent financial crisis. During the crisis period, the term spread became a strong predictor while the stock market volatility lost its predictive power. Finally, future research may be fruitful by more thoroughly examining the time series properties of the CMBS market movement, which is still little explored, compared to the REIT market. It would be also interesting to examine both the interactions between CMBS and REITs and between these securitized real estate markets and general financial markets in a multi-country context and how such interactions may be driven by international macroeconomic conditions. Lastly, nonlinear interdependence between securitized real estate markets and general financial markets through higher comoments (e.g., Yang et al. 2010) may reveal

520

J. Yang

more new insights about their relationships during extreme market conditions and should deserve attention in future research.
Acknowledgements We gratefully acknowledge helpful comments from Warren Bailey, Amitabh Godha, Qiao Liu, Christopher Schwarz, Ko Wang, session/seminar participants at Sun Yat-Sen University, Hunan University, 2010 Midwest Finance Association annual meeting, 2010 China International Conference in Finance, 2010 Global Chinese Real Estate Congress annual meeting, and 2010 Asian Real Estate Society annual conference. An earlier version of this paper was awarded the 2010 Global Chinese Real Estate Congress Best Paper Award. Extensive comments from an anonymous referee have greatly improved the paper. Zhou acknowledges the financial support of a direct grant from the Research Grants Council of the Hong Kong Special Administration Region, China (Project No. Chinese U 2070446).

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