Equity Indices’ Returns: Contingent Claims on GDP Stochastic Movements

Volume 13, Number 2, Second Quarter 2015

Thomas S.Y. Ho and Sang Bin Lee

This paper proposes an equity index contingent claim model. The model assumes that the equity broad-based market indices’stochastic movements are contingent to macroeconomic risk factors that are derived from Ho et al.’s (HPS, 2012, 2013) and Ho and Lee’s (HL, 2015b, 2015c) theoretical models. The results show that these factors can explain the equity indices’ returns reasonably well.

Our model accounts for the complex lagged effect of GDP growth rate modeled by HPS and estimated by HL, and determines the sensitivities of a market index to the stochastic GDP multiple factors. We show that the S&P Index seems to have anticipated the Great Recession and the higher growth rate of the current recovery. The results also show that the market premiums of Dow Jones and NYSE indices move mostly in tandem with those of S&P. However, such as not the case with NASDAQ and Russell. The model can be used for asset allocation and hedging in investment strategies, and we have provided multiple hedging strategies in this paper to illustrate some applications of our model.