Flight-to-quality or contagion effect? An analysis from the Turkish and the US financial markets

Abstract

In this paper, we investigate the presence of flight-to-quality from stocks to bonds as they are the two alternative asset classes predominantly used for hedging investment risk. A negative correlation between stock and bond markets is taken as a prognostication of flight-to-quality, while a positive correlation can be taken as a sign of contagion between the markets. We analyze the Turkish and US stock and government bond markets between June 6, 2006 and November 29, 2013, to make a comparison between the diversification benefits in a developed and an emerging market economy. We further divide our sample into two sub-periods to compare the patterns in crisis and tranquil periods. Our results reveal the existence of flight-to-quality in Turkey, whereas we find significant positive correlations between stocks and bonds in the US, implying a contagion effect. Additionally, we design portfolios of bonds/stocks and compute optimal weights and hedge ratios of the assets.