The Correlation Between China’s Stock And T-bond Market

As the time-varying correlation between stock and T-bond returns plays a pivotalrole in asset allocation and risk diversification, this thesis aims to find which potentialdriving forces can affect the correlation in China’s markets. Previous researchesdemonstrate that stock and T-bond return correlation should be positive, as macroeconomy variables such as real interest rate affect both stock price and bond price inthe same way, but the effect of inflation is rather vague. Empirical studies of westerncountries have confirmed this phenomenon. This thesis wants to study it in China.After examining different potential factors like: expected inflation, real interest rate,volatility of the stock market and return of stock market, I find the real interest rateand volatility of the stock market can significantly (under the5%significant level)affect the correlation. As volatility is usually a proxy for risk in the market, whenmarket is unrest, investor will seek for low-risk assets like T-bonds, which augmentsits trading price. This “flight to equality” phenomenon causes a negative correlationbetween stock and T-bond returns. Another contribution of this thesis is to employsome modern models, like dynamic conditional correlation model and Vasicek model,to estimate some subtle data which are not available in China.