Discussion

Modern portfolio theory (see Markowitz, 1952) proposes how rational investors should use diversification with imperfectly correlated assets in order to optimize their portfolio with respect to its expected return and its risk or volatility. Thus, the econometric analysis of Sections 3.4.2 and 3.4.3 provided information regarding the correlation and the dynamic interaction of a number of selected assets in order to assist in the construction of portfolios. This is of particular importance, especially when considering passive investment strategies, which are predominantly based on the use of market indices. Investors can diversify their portfolios across assets if this appears to be optimal in an expected risk-return sense; having all available information about asset comovements, like correlations of returns and transmission of shocks between assets, is therefore essential in making such an optimal asset allocation decision (Perold, 2004; Brandt and Diebold, 2006).

It appears that the morphology of the relationship between the market indices examined exhibits a number of differences when moving from the pre- to the post-crisis period, or from the US to the European market; this morphology is to a moderate degree similar to that suggested by previous

49 _{As a sensitivity check the VAR analysis is conducted by replacing the selected market indices with a number}

of alternative indices. The additional indices employed for the stock market include the Russell 3000 Index, and the Dow Jones Industrial Average Index for the US, and the FTSEurofirst 300 Index and the EURO STOXX 50 Index for Europe. For the corporate bond market the indices selected are the Barclays Capital US Corporate Investment Grade Index, and the Barclays Capital US Corporate High Yield Index for the US, and the Bank of America Merrill Lynch EMU Corporate Bond Index, and the iBoxx Liquid Euro Corporate Index for Europe. For the corporate CDS market, the Markit North American High Yield Index and the Markit iTraxx Europe HiVol Index are selected for the US, and the European market respectively. The VAR specification with the alternative indices yields essentially the same results with the initial indices, probably due to the significantly high correlation between intra-asset indices.

empirical studies, however considerable deviations from those studies are also manifested.50 The econometric results reveal a difference in the timing with which information is reflected in the market indices. The importance of the issue of the timing and the amount of information transmitted from one index (market) to the other lies in its use for asset allocation purposes, since informational spillovers constitute the crux of dynamic cross-market hedging strategies (see Fleming et al., 1998; Kodres and Pritsker, 2002). This difference in the reflection of information is more evident in Europe pre-crisis, and in the US post-crisis where, consistent with ‘‘friction-based’’ and ‘‘sentiment-based’’ theories of comovement (see Barberis et al., 1998; 2005; Boyer, 2011), index comovement appears to be delinked from the underlying fundamentals.51

In particular, the lead of the stock index over the corporate bond and CDS indices in Europe pre-crisis, suggests that during this period the corporate bond and CDS markets are not fully integrated with the stock market. Thus, information about fundamentals appears to be reflected first in stocks and consequently transmitted to corporate bonds and CDSs. This is in line with previous studies, as well as with the overall status of financial integration in the pre-crisis EMU, which was still at a lower degree compared to the US. Post-crisis however - and still within the EMU - corporate bond and CDS indices begin to impact on the stock index, showing signs of increasing financial integration. Part of this is reflected in the post-crisis results, where stock returns affect more frequently (and at more lags) corporate bond returns and CDS spreads. This supports the theoretical propositions about the role of volatility as an important driver of market integration (see French and Roll, 1986; Hamao et al., 1990; Longin and Solnik, 1995; Andersen, 1996).

In the US, the corporate CDS and bond markets appear to be significantly more integrated with the stock market however, daily corporate bond index returns do not affect stock index returns pre-crisis. This pre-crisis lack of integration between stock and corporate bonds is largely attributed to the period during the crisis (July 2007-September 2009), where unreported results show that corporate bond index returns are uninformative for stock index returns, while their correlation is close to zero.

50 _{A detailed presentation of the previous studies' findings is provided in Sections 2.2, 2.3.1, and 2.3.2.} 51 _{For a discussion of the ‘‘friction-based’’ and ‘‘sentiment-based’’ theories of comovement see Section 2.1.}

This is not surprising, since there is evidence that at daily or even higher frequencies, the stock-bond correlation decreases during periods of high stock market uncertainty, mainly due to the flight-to- quality phenomenon (Connolly et al., 2005; 2007). Hence, in the event of severe market stress the diversification benefits among the stock and bond indices vanish, thus creating the need for alternative assets which, when used in combination with stocks, result in greater diversification (Connolly et al., 2005; Yang et al., 2009).

It might be the case that the regulatory reforms implemented by ISDA since July 2002 have not improved the transparency and liquidity of the corporate bond market (contrary to Edwards et al., 2004; Bessembinder et al., 2006; Goldstein et al. 2007; Downing et al., 2007). The generally small impact exerted by the stock index on that of corporate bonds could be also justified by the fact that the information transmission from the stock to the corporate bond index occurs within the same day, as it is the case with scheduled macroeconomic announcements. As mentioned above, the post-crisis dynamics between the US indices, are in line with those suggested by previous theoretical and empirical studies, and also similar to those in Europe pre-crisis, i.e., the stock index leads the corporate bond and CDS indices. However, there is also evidence about a relatively low degree of integration between the stock index on the hand, and the corporate bond and CDS indices on the other, thus lending support to the theoretical notion that a fall in liquidity reduces the impediments to arbitrage, which is considered as a fundamental factor of the equity-credit market integration (see Kapadia and Pu, 2012).

A significant and common finding for both the US and European markets after the crisis, is the low correlation and decreased interaction between the corporate bond and CDS indices, thereby lending support to the arguments that correlation between similar assets decreases with illiquidity (Beber et al. 2009). However, while in Europe it is the corporate bond index that appears uninformative for movements in the corporate CDS index, in the US the reverse occurs.52 _{This in turn}       

52 _{This might be attributed to the lower liquidity (in terms of the mean and standard deviation of their bid-ask}

spreads and of the transactions volume) of the bond market relative to that of the CDSs within the European market, while in the US while the reverse occurs.

acts as a limit to the ability of investors to obtain a perfect hedge when investing in the credit market, i.e., as a limit to arbitrage (see Schleifer and Vishny, 1997; Duffie, 2010). This occurs through the impact on the CDS-bond basis, thereby altering the arbitrage and/or hedging opportunities when trading the basis and resulting in significant profit variations; this is also verified by Bai and Dufresne (2011), offering as a potential explanation the counterparty risk and the collateral quality (in this case the corporate bonds).53