N°23-106: A Joint Factor Model for Bonds, Stocks, and Options

Motivated by structural credit risk models, we propose a parsimonious reduced-form joint factor model for bonds, options, and stocks. By extending the instrumented principal component analysis to accommodate heterogeneity in how firm characteristics instrument the sensitivity of bonds, options, and stocks, we find that our model is able to jointly explain the risk-return tradeoff for the three asset classes. Just six factors are sufficient to explain 31% of the total variation of bond, option, and stock returns; these six factors leave the returns of only 7 out of 169 characteristic-managed portfolios unexplained. Finally, we investigate the patterns of commonality in return predictability.