Empirical Essays on Asset Pricing in the Chinese Stock Market

This thesis empirically studies asset pricing in the Chinese stock market. It consists of four separate but closely related essays in Chapters 2-5, respectively. The first essay tests the validity of the standard Fama-French model in the Chinese Main-board stock market within a relatively new sample period since quarterly financial reports became widely available. The empirical results confirm the good performance of the Fama-French model. By splitting the sample into two sub-periods representing two different market tendencies, the Fama-French model performs better but is less stable in the downward trend than the fluctuating market. The potential explanation is also provided. The complexity of traditional methods to construct the Fama-French factors limits the model's popularity. The second essay examines a simplified method to construct the factors using the Chinese style indices. The results show that the style index-formed factors lead the Fama-French model to better explaining equity returns and producing less pricing error. The finding is meaningful in the sense that it dramatically lowers the barrier to examining and applying the Fama-French model in both academic research and financial practice. However, the theoretical foundation behind the Fama-French model, i.e., which macroeconomic variables fundamentally determine the model's success, is not clear. The rest two essays make efforts to find the answer. The third essay examines the extent to which the market, size, value and momentum factors can be linked to fundamental macroeconomic variables. We find that the momentum factor consistently captures the current economic risk as well as predict future GDP growth in China. In contrast, there is no consistent relationship between the market, size and value factors and macroeconomic growth. This finding contradicts Liew and Vassalou's (2000) conclusion that the Fama-French factors can generally predict future real GDP growth in ten developed countries. The fourth essay examines whether the ability of the above four factors to explain the cross-sectional variation in equity returns, if any, stems from the fact that they are proxies for fundamental macroeconomic risk associated with future GDP growth. The results show that the market, size and value factors together contain some overlapping innovative information about future real GDP growth, and thus, reconcile previous findings in the US (Vassalou, 2003) and Australian (Nguyen et al., 2009) markets. Some possible explanations are also discussed.