Tail risk and Flight-to-Safety

Using information from equity and Treasury bond options, I propose a new Flight-to-Safety (FTS) regime-switching model with time-varying stock-bond correlation and regime-switching probabilities. I document that the inclusion of higher-order moments such as tail risks is crucial to capturing Flight-to-Safety. In particular, heightened bond tail risk tends to diminish investors’ inclination toward Flight-to-Safety, and time-varying tail risk correlation helps explain return correlation. With verified forecasting performance, I then apply my model with FTS probability-based asset allocation to prove that it significantly outperforms other standard strategies.