Abstract
Using daily data we show sudden, extreme declines in the U.S. stock market for crash dates to lead to a capital preserving (as opposed to strategic or tactical) reallocation to government debt securities. In most cases we find flight-induced reallocation reverses direction within one day of a crash. However, for the 1987 world crash we find increased and persistent return volatility in both equity and bond returns lasting up to five days following this dramatic decline in world equity prices. Like previous research in this area, we find equity crashes alter long-run stock/bond return correlations and lead to increased stock and bond return volatility. Finally, we describe the somewhat unique stock and bond correlation adjustments triggered by the 9/11 attack and the impact this event had on the behavior of U.S. equity investors’ flight-to-safety reaction.
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Notes
Prior to regression estimation using these pre-identified event dates we apply the Inclan-Tsiao (1994) variance change point method to the stock and bond return time series over the 1984–2006 period. This cumulative sum-of-squares method is based upon an iterative two-step approach where potential return breakpoints are first identified and then confirmed. We therefore let the data in conjunction with the Inclan-Tiao algorithm determine the crash dates prior to using them in the regression model. See Smith and Brocato (2010) and Smith and Bracker (2003) for applications of the Inclan-Tsiao technique.
Neither U.S. corporate grade debt nor foreign government sovereign debt are included in the model estimated in this paper. Informal statistical tests suggest that these alternative assets do not provide a temporary safe haven for equity investors during the crashes studied. These tests are available from the authors upon request.
Since Table 2 only reports data for days t and t + 1 it omits three equity decline dates in what was a reverberating sequence of crashes in October 1987. On Friday October 16, the S&P 500 index declined by 5.29 percent, while the U.S. government bond market index increased by 0.11 percent. On Monday, October 26, U.S. equities declined by 8.64 percent, while government bonds increased by 1.58 percent (see Table 3 for supporting regression evidence). Finally, on Tuesday, October 27 U.S. equities increased by 2.39 percent while bonds decreased by 1.19 percent. Checking the daily data through Monday November 2, we find no other significant positive or negative percentage changes in either the stock or bond indexes.
While other methodologies are available in the empirical finance literature to test for time-varying correlations (e.g., ARCH, DCC, copulas, Markow switching, etc.), we choose the Dufour dummy variable technique because the estimated intercept shift estimates allow for straightforward economic and statistical interpretation of investor crash response we are interested in.
The model is estimated without slope dummies. Tests for changes in the slope coefficient using dummy variables produced statistically insignificant results.
We point out that the previously-cited Inclan-Tsiao procedure does identify a shift breakpoint with a statistically significant increase in the variance of equity returns on this date.
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Brocato, J., Smith, K.L. Sudden equity price declines and the flight-to-safety phenomenon: additional evidence using daily data. J Econ Finan 36, 712–727 (2012). https://doi.org/10.1007/s12197-010-9147-6
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DOI: https://doi.org/10.1007/s12197-010-9147-6