Essays in asset pricing

This thesis examines the cross-sectional patterns in average stock returns for A shares in the Shanghai Stock Exchange (SHSE) and Shenzhen Stock Exchange (SZSE) over the period 1995–2008. The objective is to understand stock price behavior in emerging markets and their degree of conformity with more developed markets. The thesis contains three linked studies. The first study examines whether value stocks outperform growth stocks in the SHSE and SZSE for A shares. Here we also investigate whether superior performance is related to uncertainty of outcome as captured by investors’ divergence of opinion. We document that book-to-market, sales-to-price, earnings-to-price, and cash flow-to-price ratios are significant in explaining expected returns for Chinese equities and conclude that value stocks generate returns superior to those of growth stocks. We also document that investor divergence of opinion is indeed important in explaining the superior returns of value stocks. The second study considers the applicability of the Fama–French three-factor model in the context of Chinese stock markets. We examine the model under up and down market conditions. Our results show the Fama–French three-factor model's striking success in describing the cross section of stock returns in China. We account for the model’s applicability in relation to a number of factors, notably, underlying firm “fundamental” performance (earnings, cash flow, and sales) and risk exposure (stock volatility and leverage). We also report that stock momentum suggests an explanation for the book-to-market effect. Additionally, we report on the competing “factor-based” and “characteristics-based” explanations for the Fama–French three-factor model's applicability in the context of Chinese stock markets. The final study examines whether there is a post–earnings–announcement drift (PEAD) effect in the Chinese stock markets and analyzes potential determinants of the drift. We also examine whether such drift is priced as a risk factor in stock returns. The study documents that stocks with higher positive earnings surprises have higher magnitudes of drift and those with lower negative earnings surprises have lower magnitudes of drift. We show that market risk and trading volume are significant in explaining PEAD for Chinese stocks and that the drift factor is significantly and positively related to stock returns. Overall, the thesis contributes to the existing literature by providing clear evidence that, notwithstanding the perception of market irrationality in China, many patterns in average stock returns in developed markets also occur in the Chinese market. First, value stocks have higher returns than growth stocks in China and the superior returns are related to divergence of opinion. Second, the Fama–French three-factor model is competent in explaining stock returns in China; that is, firm size and the book-to-market ratio are systematically related to stock returns. Third, the PEAD effect is also confirmed in China. From a practical viewpoint, this thesis contributes to our understanding of stock price behavior in an emerging market and offers implications for investors.