A Bond Price Puzzle: A Partial Hedge Against the Chinese Hyperinflation

Abstract

This paper studies how bond traders' extreme beliefs of repayments led to bond market anomalies. The conventional valuation model states that the value of a bond is the sum of the present values of its future cash flows. However, the prices of the consolidated government bonds soared up to thousands of times their face values from 1946 to 1948 during the Chinese Civil War. I find that (1) the bond prices anchored the Shanghai wholesale price index amid hyperinflation; (2) the extreme price pattern was primarily explained by the bond traders’ evolving belief that the government would repay the bonds with an appropriate multiplier after implementing the Currency Reform; (3) the belief was significantly affected by relevant news about repayment. On a weekly average basis, one more positive news about the Currency Reform will lead to an 8.8 percentage points increase in bond price growth rate, while one additional negative news about the repayment with multipliers will decelerate the growth rate by 8.2 percentage points; and (4) at least before the eve of the Currency Reform, the Shanghai financial markets were not sensitive to political uncertainties resulting from the Civil War.