This paper does three things. First, it explores the type of asymmetry in exchange rate correlation for five inflation-targeting countries. We show their currencies co-move more closely with the currencies of some influential foreign countries during joint appreciations than joint depreciations against a world currency. Second, it establishes empirically the linkage between interest rate differentials and exchange rate correlation. We find evidence that both widening and narrowing interest rate differentials will reduce the correlation. Third, it proposes a new version of the asymmetric dynamic conditional correlation model. The model proves to be capable of providing great insight into the two issues investigated.

We investigate the impacts of policy and information shocks on the correlation of China’s T-bond and stock returns, using originally the asymmetric dynamic conditional correlation (DCC) model that allows for the coexistence of opposite-signed asymmetries. The co-movements of China’s capital markets react to large macroeconomic policy shocks as evidenced by structural breaks in the correlation following the drastic 2004 macroeconomic austerity. We show that the T-bond market and the bond–stock correlations bear more of the brunt of the macroeconomic contractions. We also find that the bond–stock correlations respond more strongly to joint negative than joint positive shocks, implying that investors tend to move both the T-bond and stock prices in the same direction when the two asset classes have been hit concurrently by bad news, but tend to shift funds from one asset class to the other when hit concurrently by good news. However, the stock–stock correlation is found to increase for joint positive shocks, indicating that investors tend to herd more for joint bullish than joint bearish stock markets in Shanghai and Shenzhen.