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Multifactor conditional equity premium model: Evidence from China's stock market

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  • Cheng, Hang
  • Guo, Hui
  • Shi, Yongdong

Abstract

There is mixed evidence of a positive relationship between the stock market risk and return. We reexamine this critical implication of asset pricing theory using fresh data from China's stock market, which is largely segmented from the rest of the global financial market. Using formal variable selection methods and a comprehensive set of predictor variables, we identify conditional market variance, scaled market prices, and inflation as crucial determinants of equity premiums. The estimated simple risk-return relationship exhibits downward omitted variable bias, which underlines the importance of considering multiple factors to explain the variation in equity premiums. We cannot wholly attribute the three-factor conditional equity premium model to data mining, as Guo, Sanni, and Yu (2022) select the same model for the U.S. stock market. These findings challenge existing asset pricing models and provide valuable guidance for future theoretical research.

Suggested Citation

  • Cheng, Hang & Guo, Hui & Shi, Yongdong, 2024. "Multifactor conditional equity premium model: Evidence from China's stock market," Journal of Banking & Finance, Elsevier, vol. 161(C).
    • Handle: RePEc:eee:jbfina:v:161:y:2024:i:c:s0378426624000372
    DOI: 10.1016/j.jbankfin.2024.107117
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    Keywords

    Time-varying equity premiums; Stock market variance; Omitted variable bias; Multifactor model; Monetary policy; Intertemporal capital asset pricing model; Limited stock market participation; Liquidity premium; Bad variance-good variance models; Variable selection;
    All these keywords.

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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