A contingent claims approach to the determinants of the stock-bond return relationship

This paper decomposes the two effects on a firm's stock and bond returns - the effect of firm's future cash flow and the effect of business risk to study the relationship between the returns of stocks and bonds issued by the same firm. Based on the contingent claims option pricing theory, we employ the firm-level data and an event study methodology, and generate hypotheses regarding the stock-bond return relationship. We show that, by controlling for firm's leverage and firm's future cash flow has a simultaneous positive effect on the firm's stock and bond returns, whereas firm's business risk has a decoupling effect on stock and bond returns. In addition, we provide evidence for the 'flight to quality' hypothesis at a firm-specific level. Our findings complement the literature of stock and bond correlation within a theoretical framework.