Dynamic Conditional Correlations between Chinese Sector Returns and the S&P500 Index : An Interpretation Based on Investment Shocks

This paper examines the dynamic conditional correlations between the Chinese sector returns and the S&P500 index returns and offers an interpretation for the heterogeneity of sector-level return correlations. Using a sample of 12 Chinese sectors for the period of 2006-2014, we find that their conditional correlations with the S&P500 index vary significantly across sectors and across the two crises, namely, the 2008-2009 Global Financial Crisis and the 2010-2011 European Debt Crisis. To provide an economic interpretation for the dynamic conditional correlations, we lean on the general equilibrium model, as suggested by Papanikolaou (2011), in which the heterogeneity of sector-level conditional correlations can be associated with the heterogeneous sensitivities to investment shocks. We finally verify our interpretation by investigating the relationship between sector-level conditional correlations and industry-specific investment opportunities. Our main finding is that investment opportunities, as proxied by book-to-market ratio, capital expenditure, long-term debt ratio, growth rate of industry size, and Tobin's Q, are significantly associated with the magnitude of the dynamic conditional correlations. This paper thereby advances our understanding of industry heterogeneities from the perspective of industries' responses to investment shocks