Abstract
China's stock markets have grown rapidly since their inception and
have become an increasingly important emerging market for international
investors. However, there are few systematic studies on how asset
prices are formed in Chinese domestic equity markets; popular financial
media even depict the market as irrational. In this paper, we study
the asset pricing mechanism in the nascent Chinese stock markets,
with the objective of identifying variables that capture the cross-sectional
variation in average stock returns. We focus on the effects of various
market imperfections in China. We find that while the market risk
(beta) is not priced, there is a significantly negative relationship
between firm-specific risk and expected returns. Chinese investors
are willing to pay a significant premium for more liquid stocks or
for dividend-paying stocks. Furthermore, investors value local A-shares
more if there are offshore counterparts (e.g., B- and H- shares)
for foreigners, implying that a Chinese firm with a foreign shareholder
base has a lower cost of capital, ceteris paribus. Lastly, as with
U.S. and other mature markets, firm size and the book-to-market ratio
are systematically related to stock returns. Given market imperfections,
stocks are priced rather rationally in China, despite the widespread
perception to the contrary.
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