Abstract
Using a modified DCC-MIDAS specification that allows the long-term correlation component to be a function of multiple explanatory variables, we show that the stock-bond correlation in the US, the UK, Germany, France, and Italy is mainly driven by inflation and interest rate expectations as well as a flight-to-safety during times of stress in financial markets. Based on the new DCC-MIDAS model, we construct stock-bond hedge portfolios and show that these portfolios outperform various benchmark portfolios in terms of portfolio risk. While optimal daily weights minimize portfolio risk, we find that portfolio turnover and trading costs can be substantially reduced when switching to optimal monthly weights.
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