US and China’s Stock Markets Correlation of Return and Volatility: Evidence from Time Series Model

Abstract

The US and Chinese economies are highly correlated, and so are their stock markets. This paper applies the vector autoregression model (VAR) to the daily returns of the SSEC and SP500 indexes to estimate their impulse responses to each other and uses ARMA-GARCHX models to examine the relationship between the volatilities of the two indexes. Behavioral finance studies are used to help interpret the results. The research goal is to discover how the two stock markets are correlated in terms of return and volatility spillover effect. It is found that the two markets’ returns are positively correlated as shown by positive impacts on impulse response diagrams, meaning they tend to rise or fall together. And there is a one-directional spillover effect between their volatilities, going from SSEC to SP500, which could be due to widespread Chinese investor irrationality and entry limits of Chinese stock markets. In similar correlation-themed research papers usually only volatilities are studied, and this paper fills up a gap by also focusing on return correlation through the VAR model. This paper also uses volatilities as extra explanatory variables in the ARMA-GARCHX models as an innovative method. Suggestions for investors include considering Chinese stock market volatility when evaluating the risks of US stocks and avoiding herding behaviors when making investment decisions. US regulators are recommended to pay special attention to uncertainty in the Chinese market.