Background: The red line is an index, which goes from 0 to 100, measuring uncertainty in the markets.

The dark blue line is a price index, which has a lower bound at 0, and virtually no upper bound. However since it's a fixed income index, it will tend to hover around 100, compared to a stock index which can exhibit clear strong trends. Please ignore the light blue line.

The analyst in question compared the correlation between the uncertainly index levels (not returns) and ETF index levels (not returns), pre and post the financial crisis and concluded that there is a disconnect post crisis.

My question: Is such an analysis technically correct? I've always read about never regressing prices and always returns. Specifically,

a) Whilst doing a cointegration analysis, we would have regressed the two price time series and looked at the stationarity of the error term. We would have concluded that before the crsis, the error term was stationary and post cris, it is not. How does that analysis compare to simply regressing the two series like it's done here

b) Also, since these two times, by construction are somewhat stationary (as opposed to stock prices), would simply regressing the price series be okay here?enter image description here

  • $\begingroup$ why does the FI price index hover at 100? $\endgroup$ – Nikos Nov 23 '13 at 12:28
  • $\begingroup$ The price indices for fixed income (obviously) don't incorporate coupon payments so any changes in price should be due to movements in yields (which is why I prefer to model the YTMs than the price or total return). $\endgroup$ – John Nov 23 '13 at 18:28
  • $\begingroup$ To avoid unnecessary diversion of my question, I didn't mention that the dark blue line is the CDX IG index, which is measured in spread. By construction it is mean reverting to 100. Here are more details if you wanna get into how the index works. markit.com/assets/en/docs/products/data/indices/… $\endgroup$ – nonbaryonic13 Nov 24 '13 at 15:47
  • $\begingroup$ Some people regress against price levels to get a measure of realized skew. Above, the interpretation could be that a certain level of uncertainty was priced into the CDX spread, and since then it's been suppressed from the CDX (which has nothing to do with the skew). Without knowing exactly what the red series is, it's hard to be certain, but this looks like a case for volatility/risk suppression by central bank intervention. All that said, I don't think correlation of the series is the correct approach. $\endgroup$ – experquisite Nov 24 '13 at 18:24
  • $\begingroup$ Yes, the theme was of vol suppression by central bank policy. I'm curious what method you think is more appropriate if not correlation in price levels? Correlation of returns? Or a cointegration test (Note in the simplest form, the cointegration test would just look at the stationarity of the error term from the regression done in the above analysis - so not sure how that would be significantly different from the above analysis). $\endgroup$ – nonbaryonic13 Nov 25 '13 at 15:51

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