Study on Asset Pricing Model in Chinese Stock Market

Introduction

The Asset Pricing Model illustrates the affiliation among risk and anticipated return that is applied in the costing of safety and security. The universal thought following Capital Asset Pricing Model is that shareholders require to be recompensed in two factors. The first one is time value of money and the second one is risk. Asset Pricing Model uses mapping as a theoretical states of the world into the costs of monetary assets resembling bonds or stocks. Asset Pricing Model is applied to resolve the earnings with the purpose of an asset submitted. It is significant to become aware of the diverse local marketplace, mainly because of different markets that has their own characteristics and it is desired to study them independently. Even though the worldwide financial system has been more closely connected, we can still become aware of the share costs that have apparent local characteristics. The institution of the Shanghai Stock Exchange was a gigantic expansion step in the Chinese Stock Market.

In the precedent three decades, stock market in China has concerned each and every sight in the world. There are therefore a lot of queries on the subject of its enormous marketplace capability and impressive expanding momentum in long word. In common, perhaps the Chinese Stock Market place is neither mainly managed nor well-organized; but absolutely the most concerned stock market. “All asset pricing models amount to alternative ways of connecting the stochastic discount factor to data. At the same time, we will study lots of alternative expressions of p = E (mx), and we can summarize many empirical approaches by applying them to p = E (mx). By separating our models into these two components, we do not have to redo all that elaboration for each asset pricing model” (Cochrane 2001, p.27).

The costs are forever visualized as without having apparent reason. That is, the situations of the globe root them. It is not the other method of the region in an asset pricing form. Surrounded by all characteristics of monetary marketplaces, stock market is very significant. In view of the primary set up of the stock market, all examiners and depositors are inclined to “correct” costs for the shares; thereby utilizing their earnings in the best possible way. Many of the organizations stock market in Chinese marketplaces has habitually been divided between limited modules of shares for household residents and foreign personnel.

The depositors in the stock marketplace put on earnings mainly from two bases: firstly, it is from dividend imbursement and capital put on from trading shares. Chinese financial system is rising with an annual rate of 9-10%; while the financial system in the United State expands at the rate of 3-4%. This resulted in enormous financial expansion. The enormous financial expansion generated a large variety of opportunities for the depositors all around the earth. China has turned out to be the earth’s third major stock market. ”The Chinese model, if we can call it that, is merely a more corporatized-cum-statist version of the West’s regulatory democracy. If one projects the trends of the current Western status quo, one might be tempted to conclude that China is the destination. Likewise, if China continues to “evolve,” then its destination is irredeemably that of Western Europe or the United States. There is not that much separating these three “super states” – shades of George Orwell, of course” (Chin’s Potemkin stock market, 2010). It is truthfully a vision of the kind and has offered much in the method of opportunities for its determined, obedient and hard-working general public. But to suppose that, China is in any means a complimentary or non-restricted civilization as naive. Chinese Stock Market has been accounted to have exclusive characteristics that confront customary asset pricing forms and the assumption of rationality. “The embryonic Chinese Stock Market has attracted much attention because of that country’s rapid economic growth and the desire of foreign investors to participate in potential growth at the ground floor level. Accordingly, state-owned enterprises were authorized to issue a predefined mix of five classes of shares: shares owned by the state, legal person shares, employee shares, class A shares, and class B shares” (Article: The Chinese Stock Market : An examination of the random walk model and technical trading rules, 2007).

By means of Capital Asset Pricing Method, we can presume that there are no transactional expenses or levy and asset protections are isolatable into minute small packets. The particular Asset Pricing Model in Chinese Stock Market is one of the basic subjects in monetary economics. It has unquestionably played a vital role in safety or security proceeds; making forecasting and venture judgments. In order to study the Assent Pricing Model in the Chinese Stock Market, Fama-French Three Factors Model can be utilized by depositors who are concerned in stock markets in China to choose asset portfolios and assess their presentation or performances. “Results in the three-factor regression analysis show that dispersion in analysts’ earnings forecasts has a positive relationship with market risk, negative relationship with firm size, and positive relationship with book-to-market value ratio.

The four-factor model reflects that momentum is a sensitive factor only to firms in the mid-dispersion category” (Gladie & Connie 2009, p.3).

This study is mainly focusing on examination and development of the Fama-French Three Factors Model in the Chinese Stock Market. After the submission of an application and examination of the Unique Three Factors Model, the study means to construct a more closely connected form to the stock pricing in the Chinese Stock Market. By way of rise in the market stock prices and the hypothetical prices, the Fama-French Three Factors Model can assist the users to create the more accurate monetary decisions. The shareholders in the stock market achieve earnings from two sources. They are the bonus payment and assets gain from trading shares. This study will be focused on the capital gain method only. China Stock Digest provides real time Chinese Stock Market research to identify the best investment opportunities in the new Chinese Economy.” For a long time, China’s stock market behaved like an Internet stock with a small free float. The recent reforms have made all the shares liquid. Maybe China’s valuations are becoming normal because stocks aren’t valued by off-market trading at a discount anymore. It is a sign of progress” (Chin’s stock market has become a poor man’s casino: Andy xie, 2010). Research aims and research objectives helps to focus on and to understand the asset pricing model in the Chinese Stock Market. The research methodology and its analysis help to get the most accurate data for the proper research. Background of the study and Chinese Stock Market features provides more clarification as well as more information about the Asset Pricing Model. Study also helps to find out the expected outcomes and anticipated limitations of the study.

Background

The background of this research dissertation is the Chinese Stock Market. The study has been conducted specifically in the Chinese Stock Market abbreviated as CSM. For the purpose of this study; the nature, features and characteristics of the CSM has been studied. The salient features of the CSM have been taken into consideration while conducting the research on this topic. The use of the Capital Asset Pricing Model in the CSM has been studied. The Fama French Three Factor Model has been studied and its importance in this dissertation is immense. Foreign companies cannot easily operate business in China. They should function through a foreign investment enterprise. There is high level of government participation in the rules and regulations of the CSM. There are two big stock exchanges in China, the Shanghai Stock Exchange and the Hong Kong Stock Exchange followed by the Shenzhen stock exchange. “The market capitalization of domestic shares trading on both exchanges (Shanghai and Hong Kong stock exchange) reached an aggregate high of over $6 trillion in 2007. Although market capitalization fell during 2008 due to global financial crisis to $2.8 trillion the stock market valuations have rebounded strongly on these two exchanges during 2009. The market capitalization of shares trading on this exchange was $353 billion at the end of 2008” (Stowell 2010, p.140).

The Capital Asset Pricing Model (CAPM) theory mainly describes the relationship between the risks in the stock market and the required returns of a particular stock in the market. The main purpose of using CAPM is to make a comparative analysis regarding the risks and the returns associated with a particular stock in the stock market. The CAPM model should be used in the CSM as it CSM needs to protect its shareholders which will be beneficial for the development of the CSM. While using the CAPM model, there are certain assumptions like the stockholders who are not ready to take risks and in case they are ready; they need to be compensated with high returns. The other assumption in the CAPM model is that the stockholders or the investors do not influence the price of the stocks i.e. to say that they have an independent identity apart from the stock market in the influence of stock prices. The other assumption is that there are no transactional expenses like commission, processing charges etc. Also, it is assumed that there are no taxation expenses in the stock market. The assumptions regarding the risk free rates are: “risk free rates exist with limitless borrowing capacity and universal access. The risk free borrowing and lending rates are equal. The really important assumption is that investors are content to invest their money in a limited number of benchmark portfolios” (Pahl 2009, p.19). “In the Shenzhen stock exchange, stock price movements are more changeable and variable than in the Shanghai stock exchange. The Chinese Stock Market s were full with speculators and were not operating regularly” (Suliman 1998, p.90).

Research Objectives

Aim and objective of the study provides the basic foundation for its purpose. This research focuses on the test and improvement of the Fama-French Three Factors Model in the Chinese Stock Market. So, the research aim leads to emphasis the fundamental concept of the study. Subsequent, to consider and study the original three factors form the study means to construct a more closely connected form to the stock pricing in the Chinese Stock Market. The main aim of this research is to prepare a dissertation focusing on the three main factors.

1. To identify the application of the Asset Pricing Model in the Chinese Stock Market.
2. To test and identify the Fama-French model and to develop the three factors in this model in the Chinese Stock Market.
3. To identify the usage of capital gain method in the stock market for the determination of profits.

The research objective is to carry out an autonomous and focused study on the subject and discover all the information on about the Assets Pricing Model in the Chinese Stock Market s. Chinese market consists of lot of investors than any other market.The Fama French Three Factor Models can be broadly utilize in the stock market for the reason that the three factors on which this form focuses are the marketplace revisit, the dimension consequence of the business and the book price to marketplace worth of the stock

Research Questions

Research Questions are accounts that recognize occurrence to be considered for analyzing the Asset Pricing Method in the Chinese market.

Research questions are formulated and developed in such a way that the research conducted is full. The following is a summary for my research questions:

1. Is Fama-French Three Factors form workings in the stock market in China?
2. Do shares held by the Government create major impacts on the cost of stocks?
3. Are regular trading resources impressive for the purpose of stock price alterations?
4. How has the modification in rules of government affected the performance in the stock market routine?
5. Is there more sophisticated and enhanced method for pricing stock in the bourse in China?
6. Is the use of asset based pricing model well-organized in the Chinese Stock Market?

Rationale

The rationale of this study is to determine the usefulness of Asset Pricing Model as a worthy model in the context of the Chinese Stock Market, underpinned by the Three Factor Model of the Fama- French based on Capital Gains. SML should have three factors, according to the Fama French Three factor model. The first factor is the stock’s CAPM beta, which considers the market risk of the stock. The second factor is the size of the company, assessed by its equity market value and finally we have Book Value (BV) of Equity divided by Market Value (EMV).

The rationale is based on the fact that, the hypothesis of smaller companies is being riskier than bigger companies. It is natural to expect that these companies should have more returns than larger ones. As the risk involved is higher, the larger is its returns. The rationale also considers the third factor. That is, book value of equity divided by market value. Thus in real terms, it is necessary that the rationale should consider how these studies could help to understand the financial health, invest ability and growth prospects of big and small corporate.

Resources required

All the financial, human resources are used to conduct the research study in order to understand the Capital Assets Pricing model in Chinese stock market.

Literature review

China, the initial engine emerging the worldwide monetary system out of slump, is commencing to place the brake on its speedy emergent financial system and the rest of the earth is observing it carefully. A stock market has many characteristics and this distinctiveness is related to the risk, liquidity, worth, expansion probability and the cost historical record of the stocks. The Chinese Stock Market is not different. The stock market in Chinese describes very distinguishing answers like the firms which had very elevated turnover ratios in the precedent; received very low returns in the potential marketplace while the firms that had very small turnover ratios earned high returns in the future. Fama French is a methodology used in the stock market to illustrate the behavior of stocks in the marketplace in the Chinese market. Fama and French while framing the Three Factor Model has stated that the asset pricing model is a fraction of the capital asset pricing form “China’s financial market has begun to take shape and various types of financial businesses have been developed, including stocks, bonds and commercial bills. The capital loan and negotiable securities markets were gradually established after 1985. In 1988, transfer markets for treasury bonds were set up in China’s large and medium-sized cities, and stock exchanges were established in Shanghai and Shenzhen in 1990 and 1991, respectively” (Banking & insurance: Bank credit and financial markets, 2000). According to Singeing Ma in his book called the Efficiency of China’s Stock Market says that , stock market in China’s has created a progressively more significant results on Chinas financial system. Also, the most significant position that required the importance is that it has raised a substantial amount of resources ever since 1992.

The significances of the stock market to the worldwide financial system have emerged in addition. Previous, the stock market raised the exchange of deposits into reserves in the course of the intermediate banks that were virtually the only resources for financing assess in China. “The stock market has diversified the channels of financing capital available not only from within the home country but also from foreign countries. Before the market is opened, foreign investment inflows were mainly generated from foreign bank loans, foreign government debts and foreign direct investment” (Shiguang Ma 2004, p.35).

In addition to the domestic expansion of Stock market in China, the worldwide surroundings are apparently positive to the expansion of the Stock market in China. The expansion of the Stock market in China also helps to the earth’s capital marketplace. (The efficiency of China’s stock market by Shinguang Ma 2004) “With respect to domestic capital market, the Chinese corporate bond market remains underdeveloped. Although the stock market has undergone significant expansion since 1991, the large overhang of government-owned shares implies that tradable shares are only about one-third of total stock market capitalization” (Giles et al 1995, p.9).

Relevant Literature of Asset Pricing Model

According to China after WTO by Laurence J Brahm says that, stock market in China is predictable a spectator to a more quick and thrilling expansion over decade, determined by equally demand and deliver. It is predictable with the intention of, above the coming 10years:

• Marketplace capitalization will virtually quadruple.
• Amount of planned corporations will double.
• Amount of asset descriptions.
• In addition to amount of depositors will triple and amount of securities residence enhance by 1.2 times. (China after WTO by Laurence J Brahm, 2002)

Relevant Literatures of Capital Asset Pricing Method

According to Steven E.Shreve in his book called “Stochastic Calculus for Finance” mentions about the Capital Asset Pricing Model in the context of Chinese Stock Market. He says that Capital Asset Pricing Method affirms the affiliation stuck among the risk and the mandatory charge of return on assets in prolonged portfolios. Capital Asset Pricing Model offers very helpful qualitative approaching in the marketplace. But at the same time, it doesn’t give way for the accurate quantitative outcomes accessible in the course of no-arbitrage method. Capital Asset Pricing Model is done on the basis of various assumptions. The relative importance of all these assumption in the field of stock market is very much important. These assumptions are mainly the evasion of moving or operating expense, levy evasions etc. The form focus is on a sole asset phase and the portfolio’s anticipated return. The typical deviation is paying attention on a sole holding stage. Another hypothesis of this form is that all the assets are predetermined in amounts. “In well functioning capital markets an invertors should be rewarded for accepting the various risks associated with investing in as assets. Risks are also referred to as “risk factors “or factors. Asset pricing model in general terms based on risk factors as follows:

E (R_i )= ( F_{1 ,} F_{2 ,} F_{3 , …………..,} F_N )

Where:

• E (R_i) = expected returns for assets i
• F_K = risk factor k
• N =number of risk factors” (Fabozzi & Drake 2009, p.225).

He also says that, the principal asset pricing form is mainly on the basis of harmonizing supply with demand in the midst of depositors who have effectiveness, i.e. the change units of expenditure to component of pleasure. (Stochastic Calculus for Finance by Stevan E.Shreve) “The post-1998 settlement, in which the CSRC gained institutional capture of the stock market for itself is termed ‘market socialist’s regulation ‘below. Market socialist’s regulation is an arrangement of institution centered on government bureau with highly centralized powers, minimal oversight by organs outside the executive and the party, and mo participation in regulation by industry group or SROs” (Green 2004, p.23).

According to Neli A Doherty in his book called “Integrated Risk Management Technique and Strategies for Managing Corporate” says that, some of the alteration of the Capital Asset Pricing Model. These alterations of the Capital Asset Pricing Model have been prepared in reactions to some of the well-built hypothesis or assumptions. In this context, we can see that we can see many of the researchers prepared various modification on the basis of their assumptions. Some of them prepared the multi-period APM; at the same time, others prepared the CAPM by means of assorted anticipation. “In 1993, researchers Eugene Fama and Kenneth French addressed perceived weakness of the CAPM in a model with three factors, known as the Fama French model. (FFM). The FFM is among the most widely known nonpropriety multifaceted model. These factors are:

• RMRF, standing for R_{M –} R_I the return on market value-weighted equity index in access of the month T-bill rate.
• SMB (small minus big), a size (market capitalization) factor.
• HML (high minus low), the average return on two high book-to-market portfolios minus the average return on two low book-to-market portfolios” (Pinto et al 2010, p.675).

He also talk about the various experiment carried out in the CAPM and its derivatives. Former experiment of the straightforward sole beta Capital Asset Pricing Model offered a number of hold up. Later on, the experiential job favors the extra composite derivatives of Capital Asset Pricing Model in which numerous widespread features give details much of the disparity in asset proceeds. He says that a lot of the previous experiments of the Capital Asset Pricing Model had been plagued by arithmetical difficulties.

The trading of situation shares is debarred, the trading of condition owned officially permitted human being shares is restricted inside the range of condition owned venture, and affiliate of the Chinese community may buy and sell human being shares surrounded by them. Due to this cause there was deprived liquidity the significance of the circumstances owned resources or stocks could not be enlarged. (The Chinese Stock Market: efficiency, predictability, and profitability by Nicholas Grenewold). “The validity of event-study method relies much on stock market being efficient such that the CAPM can be used to capture the market influence on individual stocks. However, there exist doubts about the efficiency of Chinas stock market as they are in a flux of institutional transformation” (TakatoshiIto & Rose 2009, p.242).

According to Mohammed Osman Suliman in his book called Chinas transition to a socialist market economy says that, CAPM assess store risk of return by way of make use of the typical deviation of a store or portfolio and also by way of employing compassion of risks among a stock and marketplace safeties it is named as a beta coefficient. (China’s transition to a socialist market economy by Mohammed Osman Suliman 1993) “The Chinese economy is one of the fastest growing in the world with an average annual growth approximately 9% per year over last 13 years. Such rapid growth identifies China as an economic power playing an ever-more-important” (De Pablos & Lytras 2008, p.243).

The Chinese Stock Market was a distinguished environment of shares which had different position of profit, privileges and responsibility. The research for analyzing the Capital Asset Pricing Model is mainly by way of using the Fama-French three factors model in the Chinese Stock Market. By evaluate the marketplace stock prices and the hypothetical costs, the form can help out the users to create the accurate monetary decisions. China Stock summary offers real occasion China stock marketplace investigates to recognize the most excellent asset opportunities in the novel China financial system. “In fact, much asset pricing focuses on excess returns. Our economic understanding of interest rate variation turns out to have little to do with our understanding of risk premia, so it is convenient to separate the two phenomena by looking at interest rates and excess returns separately” (Cochrane 2001, p.29).

Relevant Literature of Fama French model

One of the milestone studies planned to conquer all these difficulties associated with the Capital Asset Pricing Model. Fama and Macbeth, demonstrated that portfolio structure and nanostructure by way of the status of the store beta in order to avoid all the difficulties. And also we can see that the Chinese Stock Market s, there were differentiated character of shares which had divergent set of benefits, rights and responsibilities. (Integrated risk management: technique and strategies for managing corporate by Neli A Doherty). ” Fama and French argue that their three-factor model removes most of the pricing anomalies with CAPM. Because of factors in the Fama-French model are specified, one can use standard regression analysis to test the model and estimate its parameter” (Lai & Xing 2008, p.87). One of the first hypothesis on which the Fama French Model is based is the stock’s capital asset pricing beta which deals with the marketplace increase of the stock.

According to Nicholas Grenewold in his book called The Chinese Stock Market: Efficiency, Predictability, and Profitability say that, the concern of the Shanghai stock trade was a giant enlargement pace in the Chinese Stock Market place with the commencement of the Chinese reserve market’s share trading had extremely unbending regulations. There were several limitations in the Chinese stock trade. “After the crisis, all six stock markets become cointegrated with Chinese Stock Market. Moreover the Chinese Stock Market is more coinintegrated with three regional counterparts than the three world leaders. Their close socioeconomic, trade, and cultural relationship with China emphasis this important feature for global investors” (Gregoriou 2009, p.443).

Literature review summary

Asset pricing process is applied to determine the earnings with the reason of an advantage will yield. It is considerable to be converted into conscious of that the assorted local marketplace it is mainly for the reason that different market has their own individuality, and it is preferred to study them separately. The aim and objective of the study helps to develop the most constructive framework for assessing the Capital Asset Pricing in the Chinese Stock Market. The methodology used to analyze the study is the Fama French method. Examination and development the Fama-French three factors model in the Chinese Stock Market helps to understand stocks prices as well as the relative information needed for the study.

Methodology

Introduction

The empirical methodology in Chinese stock market use a customized description of the active present value model put forward by Campbell and Shiller (1988). Nelson (1999) and Sharpe (2002) reformulated the unique dividend-price ratio replica into an earnings-price ratio model, by contravention the log dividends per share into the sum of log earnings per share and the dividend payout ratio. Earnings are favored to dividends as longer time series of income than dividends are accessible for China and because dividend payments are, in contrast to earnings, sensitive to the dividend payout, share buyback and tax policies. Following Boucher (2006), the tailored log linear Campbell-Shiller model can be rewritten as:

et-pt=k/1-A+Et{Epjri+j-E}-(1-A)Aa(A^i+j-Ei+j) where et-pt denotes the log earnings-price ratio at time t, κ is a parameter of linearization, A is a constant less than unity, which can be thought as a discount factor, Et{.} is the probability based on the in order set obtainable at time t, ri+j denotes log stock return during period t+j, a+j refers to earnings growth in t+j, and dt+j-et+j denotes log of the payout ratio (dividends / earnings) in t+j. Moreover, we model the expected equity return Et {rt+j} as a sum of the return of a risk-free asset (rft+j) and a time-varying equity risk premium (rpt+j). Finally, we assume a constant dividend pay-out ratio (dt+j-et+j).

In this structure, stock prices depend one-to-one to current earnings and upon unobservable variables such as the predictable prospect growth in earnings and the time-varying equity risk premium. In our experiential accomplishment we narrate stock prices to practical earnings, which replicate most dependably the earnings power because probable earnings are well-known to be biased, and to historical equity premium as a alternate for the equity risk premium, following de Bondt (2008a and b). The likely long-run stock price relation reads then as follows:

• Pt=A+B1et+B2rf1+B3rp1+et

Where pt denotes log of stock prices at time t, e log of earnings, rf risk-free interest rate, rp equity, risk premium and ε the residual. We expect the parameter B1 to be close to one and parameters B2 and B3 to be negative, given they make a replica the negative impact from the discount rate on stock prices, divided into the negative effects from the safe asset return and from the finest on risk equity.

Unit root tests are useful in order to review the time series property of the data.

Due to the small number of explanation we apply the Kwiatkowski test, where the H0 hypothesis is that the series are stationary. The KPSS tests, presented in Table 1, demonstrate that all model variables as well as substitute measures of the equity risk premium, which we believe are integrated of the order 1.

In order to examine the potential co-integration relationship among prices and stocks its aforementioned fundamental determinants, equation (2) is estimated by maximum likelihood (ML) applying the vector error correction modelling approaches by Johansen and Juselius (1990) and Johansen (1991):

• y=A1yr-1+………..+A2x-1+A3Yr-k+K+E

The (p x p) matrix, A2, characterizes the long-run relationship between the (p x 1) vector of Y variables: p, e, rf and rp. Cointegration is designated by the rank of A, r, and equals the number of cointegration vectors. The cointegration space includes a deterministic term hold a constant, K, We fairly accurate the long-run essential or fair value, fv, of the price of the stock using the fixed value of the estimated long-run model in Equation (2), value of the estimated long-run model in Equation (2):

In a second stage analysis, once stock price misalignments have been identified, we test whether there are some China-specific factors and market imperfections, i.e. stock market reforms or excess liquidity that could have a contemporaneous or lagged impact on the identified stock price misalignments:

• fvgap1=XijX1t-i+X2jXt-j+Qt

The first variable, x1, examines whether structural reform influence stock price misalignments and the second one, x2, excess liquidity, given the frequent attention in the financial press that liquidity might play a role for high stock prices.

Data

Besides the data for stock market reforms, all the variables used in the analysis are drawn from the CEIC China Premium Database and are in monthly frequency. The efficient sample period starts in April 2000 and ends in September 2006. As dependent variable we use the Shanghai A-share Index to symbolize stock price development in China. The Shanghai A-share Index is the benchmark index for renminbidenominated shares. The index refers to A-shares, where the shares of incorporated companies in China depict to more than 97% of the market capitalization of tradable shares in Shanghai Stock Exchange. Such shares can be traded by residents and restrictions are to the outside depositors.

The independent variables, i.e. the basic stock price determinants, are particular as follows. Earnings submit to reported, as different to expected, earnings because they are impartial and accessible for a longer period. The stock prices and earnings are calculated in insignificant terms as the price deflator cancel out in case of a long-run elasticity between stock prices and earnings, which certainly appears to be the case.2 As a alternative for the risk free interest rate, we use the one-year reference rate on deposits depressed by the consumer price index. The one-year time drop rate is the arrival on the less risky asset that the Chinese residents can hold, given restrictions to attain government bonds and the inherent governmental guarantee on deposits. It should be frazzled that interest rate liberalization is imperfect in China, which usually imply that successful interest rates are not entirely strong-minded by market forces and are very close to benchmark rates, especially on the deposits.

Unless stated otherwise, the equity risk premium is approximated by the one-month lagged 36-month rolling earnings yield premium (rp). The earnings yield premium is defined as the spread between the earnings yield and the ex post real interest rate. The earnings yield, i.e. the inverted P/E ratio, is commonly viewed as a reasonable approximation for the real expected return to equity (Siegel, 2005). A three-year moving average of the earnings yield premium is used. This time span is long enough to avoid that short-run fluctuations in the equity risk premium affect the long-run level of the equity premium, and thus the fair value of stock prices.

At the same time, it is short enough to capture possible structural changes in the perceived level of the equity risk premium among equity investors. As a robustness check, the following other proxies for the equity risk premium are considered: i) A one-month lagged earnings yield.

Besides the data for stock market reforms, all the variables used in the analysis are drawn from the CEIC China Premium Database and are in monthly frequency. The effective sample period starts in April 1999 and ends in September 2009.As dependent variable we use the Shanghai A-share Index to represent stock price developments in China. The Shanghai A-share Index is the benchmark index for renminbidenominated shares. The index refers to A-shares, i.e. shares of incorporated companies in China representing more than 97% of the market capitalization of tradable shares in Shanghai Stock Exchange. Such shares can be traded by residents and marginally by authorized foreign institutional investors.

The independent variables, i.e. the fundamental stock price determinants, are specified as follows. Earnings refer to reported, as opposed to expected, earnings because they are unbiased and available for a longer period. Both stock prices and earnings are measured in nominal terms as the price deflator cancels out in case of a long-run elasticity between stock prices and earnings of one, which indeed appears to be the case.2 As a proxy for the risk free interest rate, we use the one-year reference rate on deposits deflated by the consumer price index. The one-year time deposit rate is the return on the least risky asset that the Chinese residents can hold, given restrictions to acquire government bonds and the implicit governmental guarantee on deposits. It should be stressed that interest rate liberalization is incomplete in China, implying that effective interest rates are not fully determined by market forces and are very close to benchmark rates, especially on deposits (Porter and Xu, 2009 and Feyzioğlu et al., 2009). Except stated otherwise, the equity risk premium is approximated by the one-month lagged 36-month rolling earnings yield premium (rp). The earnings yield finest is defined as the spread between the earnings yield and the ex post real interest rate.

The earnings yield, i.e. the inverted P/E ratio, is frequently viewed as a rational estimate for the real predictable return to equity.A three-year affecting average of the earnings yield premium is used. The time duration is long enough to avoid that short-run changes in the equity risk premium affect the long-run level of the equity premium, and thus the fair value of stock prices.At the same time, it is short enough to detain potential changes in the apparent level of the equity risk within the investors. As a strength check, the following other proxy for the equity risk premium are considered: i) A one-month lagged earnings yield premium averaged over a 24-month period (rp24); ii) the realised excess return, i.e. the return on equity vis-à-vis the return on deposits, over a 36-month (er); and iii) 24-month period (er24). Moreover, to the size that cumulative risk in the stock market is confined by the inconsistency of the stock market return, it is reasonable to expect a positive empirical relationship between our proxy for the equity risk premium and market volatility (Kim et al., 2004). Regarding the case of China, we find definitely a positive long-run association between the equity risk premium and stock. We anticipate our proxy for the equity risk premium to capture the risk-based explanations put forward for the premium.

{Table 2 Cointegration rank test between equity risk premium proceedings and stock return insecurity}

The data for the second-stage regressions amplification stock price misalignments is obtained as follows. First, excess liquidity is calculated as the distinction in the year-on-year growth rate in loans and GDP. Second, the data used to date the stock market improvement is obtain largely from China Securities Regulatory Commission (CSRC) and complement with information from Bloomberg and Financial Times.4 Table 3 summarizes the main steps in China’s equity.

The column “Restrictive” denotes months when preventive measures were taken by the authorities, while the column “Liberalizing” denote months when slacken actions were applied. We use these dates to construct corresponding dummy variables for restrictive and liberalizing stock market reforms. We admit the limitations of our basic dummy advance as the stock market reform have not been repetitive.

Empirical results

Modelling stock prices with fundamentals

Given our interest in the stability or long-run relation of stock prices and their primary determinants, we center on the long-run connection in Equation (3). Table 4 reports the trace and maximum use of the statistics, which specify the continuation of one Cointegrating relationship linking the stock price and its primary determinants considered.

{Table 4 Cointegration rank tests}

Table 5 presents the long-run estimates of Equation (3), assuming one cointegration relation.

The delay organize is single-minded by lag prohibiting tests and at most four lags are included. Four main observations appear from the empirical results.1. The long-run earnings elasticity is expected to be close to unity and is statistically significant. Moreover, the likelihood ratio test for wages elasticity of unity cannot be rejected at the conservative levels of statistical significance. This implies that China’s stock prices move onto-one to income in the long run, when controlling for the risk free interest rate and equity risk premium. It also implies a mean-reverting P/E ratio for China over long samples, which is also practical for developed countries for which two centuries of data are available.

Table 5 also reports the estimation results, whereby the pay elasticity is constrained to one.

• The estimated long-run interest rate semi-elasticities are statistically important and in line up with the estimate for developed countries. A one percentage point enlarge in the invest rate results in 10% lesser prices.
• The expected long-run equity risk premium semi-elasticities are statistically momentous. They are superior to the estimate as reported in developed countries; signifying stock price developments in China are comparatively strongly precious by swings in the equity risk premium.
• The better stocks return some typical benchmark models, like a model with only a constant. In detail, our model depicts the each and every variations taking place in the stock market.

Stock price misalignments – dating booms and busts

One way of presenting the estimated fair value of the stock market in China is to modify the observed P/E ratio for the impact of the level of the risk-free interest rate and equity risk premium. Given the unlimited estimate of the pay suppleness revolve out not to move away appreciably from one, these estimated fair values can be seen as a P/E ratio adjusted for the interest rate and equity risk premium. The observed P/E ratio and the P/E ratio modified for the interest rate and risk premium for the restricted model. Expanded and obvious deviation between the actual P/E ratio and the estimated fair P/E ratio point to signs of long-run stock prices according to the fundamental determinants and their probability with the stock price. As can be seen from Figure 1, the actual P/E ratio is good in 2007, but returned to its predictable fair value in the course of 2008. In ending of 2008, the actual P/E ratio was below the modified P/E ratio, whereas the opposite was the case at the end of the sample period.

Next, the estimated fair valuation gaps or percentage deviations of the definite result of the stock prices from their estimated long-run fair valuations according to the estimates with freely estimated earnings elasticity. The expected long-run stock price misalignments show that authentic stock prices may diverge from their long-run value over complete intervals.

Such deviations from the fair value are a sign of under- or over-valuation, at least based on the model and samples are considered. They could, however, also reflect temporary deviations of earnings growth or the discount factor from their long-run equilibrium levels or structural changes in the long-run relation between stock prices and their determinants.

Table 7 presents the dates of booms and busts in the Chinese stock market applying a statistical (outside the one standard error of regression confidence band) and economic (more than 20% misalignment) rule to the long-run stock price misalignments derived from the unrestricted model. To be certain about the survival of booms and busts, we relate a rule where pros and cons are estimated and the using both statistical and economical criteria. The rule results in two booms and two busts periods since April 2000. The first recognized rupture took place between October 2000and February 2001. Another happened was between middle of -2004 and mid-2005. This was followed with a marked boom which started in October 2006. An innovative stock market rumble started in May 2009 up to July 2009.

{Table 7 Identified booms and busts in China’s stock market since April 1999}

Other factors explaining booms and busts

According to our model, fundamentals factors were able to explain only a part of the rise in 2006-07 and the subsequent fall in China’s equity market in 2007-08, as a main feature powerful stock price change at that time was the mistake term, i.e. the part not explain by the Fundamentals considered. Two promising explanation arise. First, the recognized run-up of Chinese stock prices in 2006-07 and the succeeding fall down in 2007-08, being either rational or irrational.

Second, there are some China-specific factors that cause the dynamic stock price model to be inadequate modelling stock prices in China. The sub-sections analysis the second option, given is not our aspiration to extend the not well developed literature on asset price. As a result, we use three additional variables to test whether they can explain the stock market misalignments recognized earlier, viz. stock market reforms and two proxies for excess liquidity. The factors could potentially give details of the characteristics of Chinese stock market and market imperfections in the model. Regarding stock market reforms, the Chinese domestic stock market was designed in the 1990s as a segmented one: a market for residents denominated in renminbi (A-share) and a market for foreigner denominated). In calculation, most of the share of the listed firm are in the hand of the community sector and are not actively traded. Since the opportunity arising of the Shanghai’s stock market in December 1990, Chinese authorities have introduced much introduced regulations, including provisions to make possible raising capital and IPOs by corporates, to diminish market segmentation and to develop the investor base.

Concerning excess liquidity, given the efficient interest rates are not completely indomitable by china markets; the liquidity circumstances in capital markets could give details stock price increase beyond the interest rate controlled for in the primary-based model.

Table 8 examines whether the loosen reforms have impacted in general stock price developments in China by regressing the expected long-run stock price misalignments (Figure 2) on a constant and the liberalizing reform dummy cumulated over a certain period. We thus examine the impact of the reforms beyond the effect they could have in affecting the fundamental determinants in stock prices, such as a structurally lower equity risk premium or a positive longer-term impact on the performance of listed companies and thus on earnings.

Two conclusions appear from these regressions: 1) Excess liquidity is normally not touching misalignments (see Panels A and B). However, in period with positive excess liquidity, it is significantly disturbing long-run stock price misalignment generally up to six months. An amplification in optimistic surplus liquidity by 1 percentage point consequences in an about 1½ percentage point superior fair valuation gap. Put differently accelerate M2 or loan growth further than nominal GDP growth seems to improve stock prices in China. Constructive surplus liquidity explains about one-third of the inconsistency in the long-run stock price misalignment and together with liberalizing reforms up to 42%. 2) The estimated impact of the liberalizing reforms vestiges statistically significant when also an excess liquidity measure is considered.

Analysis of the research

Introduction

The analysis of this research dissertation is with regard to the Chinese stock market. Study has been conducted specifically in the Chinese stock market abbreviated as CSM. For the purpose of this study the nature, features and characteristics of the CSM has been studied. The salient features of the CSM have been taken into consideration while conducting the research on this topic. The use of the Capital asset pricing model in the CSM has been studied. The Fama French three factor models have been studied and the importance of the Fama French three factor models for the purpose of this dissertation is immense. Foreign companies cannot operate business straightforwardly in China they should function through a foreign investment enterprise. There is high level of government participation in the regulations and rules in the CSM. There are two Stock Exchanges in China, the Shanghai stock exchange and the Hong Kong stock exchange, followed by the Shenzhen stock exchange. “The market capitalization of domestic shares trading on both exchanges (Shanghai and Hong Kong stock exchange) reached an aggregate high of over $6 trillion in 2007. Although market capitalization fell during 2008 due to global financial crisis to $2.8 trillion the stock market valuations have rebounded strongly on these two exchanges during 2009. The market capitalization of shares trading on this exchange was $353 billion at the end of 2008” (Stowell 2010, p.140). The capital asset pricing model (CAPM) theory mainly describes the relationship between the market risk in the stock market and the required returns of a particular stock in the market.

The main purpose of using the CAPM is to make a comparative analysis regarding the risks and the returns associated with a particular stock in the stock market. The CAPM model should be used in the CSM because the CSM needs to protect its shareholders which will be beneficial for the development of the CSM. While using the CAPM model there are certain assumptions like the stockholders are not ready to take risks and in case they are ready to take risks they need to be compensated with high returns. The other assumption in the CAPM model is that the stockholders or the investors do not influence the price of the stocks i.e. to say they have an independent identity apart from the stock market in the influence of stock prices. The other assumption is that there are no transactional expenses like commission, processing charges etc. and also it is assumed that there are no taxation expenses in the stock market. Regarding the risk free rates also there are assumptions like the “risk free rates exist with limitless borrowing capacity and universal access. The risk free borrowing and lending rates are equal. The really important assumption is that investors are content to invest their money in a limited number of benchmark portfolios” (Pahl 2009, p.19). “In the Shenzhen stock exchange, stock price movements are more changeable and variable than in the Shanghai stock exchange. The Chinese stock markets were full with speculators and were not operating regularly” (Suliman 1998, p.90).

Fama French is a methodology used in the stock market to describe the behavior of stocks in the market. According to the capital asset pricing model a stock’s beta alone should explain its average return. “Since a stock’s beta measures its contribution to the risk of a portfolio, beta is the theoretically correct measure of the stock’s risk” (Brigham & Daves 2010, p.52).

One of the first hypothesis on which the Fama French model is based is the stock’s capital asset pricing beta which measures the market rise of the stock.

The second hypothesis factor which it takes into consideration is the size of the company which is measured by the market value of its shares. There is a view point that smaller companies have more risks as compared to bigger companies and therefore the returns of a small company have higher expectations. The third hypothesis is the ratio between the book and the market value of the stocks. When market value of the stocks are higher than its book value then the stocks are good for the company while when the book value of stocks are higher then there is pessimism about the future of the stocks and they are not considered as good investments. Fama and French’s studies revealed that small companies which had high book to market ratios had considerably higher rates of return than the average stocks. They also found that there was no considerable difference between the beta in the stock market and the returns in the stock market. The high beta stocks in the stock market were not generating higher returns and vice versa.

The first factor in the Fama French three models is that the market risk premium is derived by subtracting the risk free rate from the market returns which is similar to the capital asset pricing model theory. But the di9fferences are relevant in the next two models adopted. The second factor was the creation of the SMB portfolio which can be defined as a separate portfolio in which the returns from the big stock and small stock are calculated by subtracting the return on big portfolio from that of the small one.

This portfolio was designed by Fama and French in order to gauge the deviations in the stock returns which are caused by the size of the business. The third factor was the ranking of the stocks according to their book to market ratios. Separate portfolios were created for high and low book to market ratios. “The Fama French three factor model version of the CAPM security Market line for the required return on a stock is:

• r_i = r_RF + a_i + b_i(r_M – r_RF) + c_i(r_SMB) + d_i(r_HML)

Where r_M – r_RF is the market risk premium, r_SMB is the expected value (i.e. premium) for the size factor, and r_HML is the expected value (i.e premium) for the book to market factor” (Brigham & Daves 2010, p.100).

Thus the Fama French model is mainly used to estimate the return that the stocks will be generating. Fama and French consider that the book value of the stock is the measurement of the stock’s risk. The main reason behind this idea which they suggest is that when a stock’s book value is high then it implies that the stock is of little concern and its prospect income is a little doubtful. It can also be viewed that the stock is fully of a capital nature and therefore will be generating very less income in the times of economic recession. The two situations are entirely different and so the use of this model was a little doubtful but all doubts were cleared and a conclusion was reached that this model can be used successfully in the stock market if all the three factors are used together. “It may be that the success of this model at explaining past performance isn’t due to the significance of any of the three factors taken separately, but in their being different enough that taken together they do an effective job of “spanning the dimensions” of the market” (Fama and French three factor model, n.d).

When the traditional use of the capital asset pricing method was compared with the Fama French three factor models in the Shanghai stock exchange then it revealed that in the CSM should use the three factor model very specifically. “The results show that firm size, book to market equity and idiosyncratic volatility are priced risk factors in addition to the theoretically well specified market factor” (Jiang & Stening 2006, p.94).

Chinese stock market features

The Chinese stock market is the background of our study for the dissertation. The Chinese stock market or CSM was established in the late 20^th century that is in the early 1990s. The first stock market established by China was the Beijing Securities Exchange but the establishment of the stock exchange was not furtive for the economy. The CSM also faced similar problems as faced by new stock markets regarding rules and regulations and tight liquidity of funds in the financial markets. A stock market has many characteristics and this distinctiveness is related to the risk, liquidity, worth, expansion probability and the cost historical record of the stocks. The Chinese stock market is no different. The stock market portrays a distinctive response like the firms which had high turnover ratios in the past earned very low returns in the future while the firms which had with low turnover ratios in the past earned very high returns in the future.

A stock’s risk can be classified into two parts. The first one is the market risk and the second one is the diversifiable risk. The diversifiable risk of a stock can be reduced or eradicated by expanding the business portfolios or escalating the business into new sectors. The market risk is mainly caused by the spontaneous universal movements of stocks in the stock market. The market risk of a stock is calculated by its beta coefficient which is the guide of the relevant risks of stocks in the stock market.

China’s stock market is of a developing nature as compared to the developed markets of the US and the UK. The CAPM model was not found that effective to be used in the CSM therefore the three factors Fama French model will be a better option. “The primary purpose of the stock markets was to shift state owned enterprises financing from bank loans to public funds. Another purpose was to improve corporate governance” (Neftci & Menager-Xu 2007, p.205).

The establishment of the Shanghai stock exchange was a big development step in the Chinese stock market. The main interest holders in the CSM are the international investors and the domestic investors. With the development of the CSM there has been a considerable improvement in the securities firms like the major banks, the government financial departments, the trusts and the investment corporations. There was a considerably high amount of over speculation in the CSM which turned to be very risky for the company and so the government started intervening and started regulating the securities firms and imposed a control. In the year 1996 the CSM faced severe problems and declared 16^th December1996 as “Black Monday” because of the excess over speculation in the securities market mainly by the Shenzhen Development bank. The capital gain method is the most suitable for the CSM because the firms in the Chinese stock exchange do not distribute many dividends.

Characteristic features of a CSM

Organized – China has a very small bond market. In China there was a mixture of both socialism and capitalism. Because there were salient socialist attitude in the state ownerships and there was strict capitalist or monopolist control in the financial dealings. The practiced mixture of socialism and capitalism turned the CSM weak and the interest of the shareholders were not properly addressed. The CSM was developed under a very weak and fragile framework which did not offer to its shareholders any protection or for that matter provided least protection so shareholders were apprehensive in investing.

The domestic stock market of the Chinese stock market is highly fragmented and has different types and categories of shares each of which has an independent identity. Such a wide fragmentation or segmentation has turned the CSM a highly distorted market because the investors in this market have different investment ideas and alternatives. The shares of the same company are represented on different markets and this affects the liquidity in the CSM negatively. A distorted market also hampers risk sharing in the CSM. “The risk adjusted mean stock market returns are low and the volatility of returns is high in china relative to developed markets. Moreover, returns are positively auto correlated to a greater extent than in the developed markets” (Choi & Doukas 1998, p.270).

Rules and regulations – the CSM was strictly under the control of the government. “The government used it largely as a fundraising vehicle for funding state-owned enterprises (SOEs). As a result, most listed enterprises were state controlled, with only one-third of the enterprises’ equity capital sold to private shareholders during initial public offerings (IPOs). The other two thirds of the equity capital raised were held either by state asset management agencies or by SOEs themselves” (Wong 2006, p.3).

For all operations in the CSM the government has full control. The initial public offerings are also scrutinized by the government. The government prepared the quota needed for new listings of companies until the year 2001. “Under current laws in China, no company is allowed to list without three years of continuous profitability” (China stock market in a global perspective, 2002, p.22).

In the beginning of the Chinese stock markets share trading had very rigid rules and there were a lot of restrictions in the Chinese stock exchange. Previously the trading of state shares was banned and trade was only conducted within the state. “The trading of state shares is banned, the trading of state owned legal person shares is confined within the scope of state owned enterprises, and members of the Chinese public may trade individual shares among themselves” (Groenewold, N., 2004, p.17).

Due to this reason there was poor liquidity in the Chinese stock exchange and also the worth of the state owned assets or stocks could not be increased. In the Chinese stock markets there were distinguished nature of shares which had dissimilar set of benefits, rights and obligations. The policy on state shares was such that shares could not be traded with the shares of permissible persons. Only individual shares could be sold which was less than one third of the total shares issued. This was a total loss to the economy and the Chinese economy was not developing especially the CSM. This resulted in the development of an unreasonable equity structure in the companies in China and there was a severe non liquidity of funds in the CSM and the composition of shares listed in the stock exchange was not favorable. Previously the CSM‘s A share market which constituted of small individual investors lacked the expertise and the qualified skills needed to earn profits in the CSM. They also ignored the fundamental concepts like the price earning ratios and laid full emphasis on capital gains. China has somewhat compromised on its strict regulations and the country has permitted many enterprises both domestic as well as international to enter the Chinese stock market and many enterprises has been listed in the CSM. The selection of these companies has been mainly based on the basis of the sector of operation of the company and also on the basis of raising of funds or capital investments. The best solution to further increase their investments was to also incorporate the non- state sector , therefore the revision of Chinese constitution was needed so that non state sectors also get lawful acknowledgment and capital markets could be operated in the non state sector.

Policy driven market – the CSM is called a policy driven market because in the CSM politics and administrative interferences at each state level play a more important role rather than the competition factor in the market and the price fluctuations. Another institutional character of the CSM is the closed nature of the A share market. The A share market was under the full control of the government. “The insular nature of China’s A stock market means that price movements may not necessarily be influenced by short term US stock market performance” (Mitchell & Ong 2006, p.10).

Political situation – the CSM is heavily dependent upon the political situation of the country. The CSM was inclined towards the socialist politics. And sometimes the CSM is termed as a marriage between capitalism and socialism.

Segmented market – the CSM is called a segmented market because there are strict rules for trading such as the state owned shares in the CSM could not be traded with the legal person shares. The CSM is also divided into A share and B share markets which has different rules and regulations and are traded in the Shanghai and Shenzhen stock exchanges. The A shares could be purchased only by the Chinese residents while the B shares are to be purchased by the foreign investors. Capital gains from B shares could be sent to the respective foreign countries and can be traded in US dollars also. The B shares cannot be converted into shares.

Casino type – the CSM is considered as a casino. “The bear market is the rule, but the few appearances of a bull market with high capital gains are such that, overall, it is possible to make some profits with such a strategy. Risk, as measured by the variance of capital gains, is skyrocketing in the speculative market. Overall, the ‘Casino’ character of the Chinese stock market is the main feature that is substantiated by the present results” (Girardin & Liu 2003, p.10).

Uneven and irregular – the growth of the CSM can be framed as uneven and irregular. The CSM as compared to the stock markets of other countries which was established during the same time period has shown a very developed trend. But the CSM cannot be predicted because of the over speculative factor in the CSM. “China’s crazy stock market resembles its hypertrophic economy in repeatedly having the last laugh on pessimists’ predictions, leaving at least some experts wary of forecasting what the price level of China’s stock market will be, or how a major adjustment might take place. It appears that as with ‘socialism,’ stock market bubbles in China have some indefinable ‘Chinese characteristics” (Jing & Kelley 2007).

The Chinese stock market has a bubble character and this is caused due to the huge dominance of the state owned enterprises. The state owned enterprises are dominant in all fields like in the case of listed companies. The burst of the bubble will cause a big harm to the shareholders and the stockholders will stage a big rebellion but the bursting of the bubble is of little possibility because the Chinese government has a full control over the stock markets.

Deficiencies in the Fama French Model

Limitations of the Fama French model in the CSM are that this model cannot be used widely in companies. Studies conducted reveal that there is a argument regarding that the size effect of a company effects the stock returns. There had been many cases in which there is a contrast point regarding the concept that the size of the company affects the returns on the stock of the company. Another drawback of this three factor model is that the book to market ratio of stocks is not very accurate because the company’s assets constitute of both physical assets as growth opportunities and this mixture changes from time to time and thus it will not be able to portray the correct book to market ratio. The Fama French three factor models can be widely used in the stock market because the three factors on which this model focuses are the market return, the size effect of the company and the book value to market value of the stock.

The CAPM model states the relationship stuck between the risk and the obligatory rates of return on assets in expanded portfolios. The CAPM model is based on many assumptions like the evasion of transportation expenses, tax evasions. In the CAPM model all the focus is on a single holding period and the portfolio’s expected return and standard deviation is focused on a single holding period. Another assumption of this model is that all the assets are fixed in quantities. “The capital asset pricing model is based on balancing supply with demand among investors who have utility functions that convert units of consumption to units of satisfaction” (Shreve 2005, p.70).

Fama and French while framing the three factor model has stated that very asset pricing model is a part of the capital asset pricing model. There have been many theories supporting the CAPM theory like the multiperiod asset pricing model, the capital asset pricing model with heterogeneous expectations and the arbitrage pricing model. “Earlier test of the simple single beta CAPM provided some support; later empirical work favors the more complex derivatives of CAPM in which multiple common factors explain much of the variation in asset returns” (Doherty 2000, p.151).

Empirical data

Stock prices with basics

The interest in the balance in the long-run connection of stock prices and the primary constraints, we center on the long term relationship in the stock exchange and integrate relationship which links the stock value and its elementary determinants measured.

1. The long-run income suppleness is predictable to be close up to unanimity and is statistically important. Besides, the probability ratio examination for earnings elasticity of unity cannot be discarded at the conservative level of statistical consequence. This implies that China’s stock prices move one-to-one to paycheck development in the long run, when calculating for the risk at no cost rate and fairness risk premium. It also implies a mean-reverting P/E ratio for China over long samples, which is also practical for residential country for which the data are existing.
2. The probable long-run attention speed are statistically significant and in line with the approximation for residential countries as in the report. A mere increase in the percentage enlarge in the investment rate which gives a results in 10% reduction in the stock rates.
3. The expected long-run impartiality risk premium are statistically significant. They are advanced than the approximation as information depending on the stock value development in China are reasonably powerfully get affect by rock in the premium of equity.

Quantitative Analysis

Considering the results obtained from the sample study of 100 respondents in the context of Chinese stock market member companies, it was seen that 5% of the responses was rejected due to incomplete applications and technical errors. The differentiation of the accepted 95 applications was as follows:

From the above results of the survey, it is seen that the majority of respondents drawn from industry are inclined towards use of F& F Model in the context of the Chinese stock exchange. (52% are in favour).However, it would also be necessary to consider the other aspects also, in terms of the proportion of respondents, who either strongly disagree or just disagree with their use (32%).

The quantitative research is the organized analyzing and investigation of the quantitative data. The idea of the quantitative method is the employment of the mathematical and statistical model and the analysis of the hypothesis. The quantitative link is the main link between the empirical methods and the mathematical analysis. The first hand information is obtained in the quantitative data analysis.

The quantitative data are the main usage of the quantitative variables and they are measurement oriented and based on the results. The different tasks involved in them are; identifying the three model factor analysis in the stock market, the returns that are expected and the outcome of the analysis. The fresh hand information on the data is included and the analysis is done by the comparison method which is included in the research.

Qualitative Research

This method of research is appropriated in several diverse scholarly disciplines. The qualitative design finds it useful mainly in the research and in the application of qualitative research methods to collect a thorough understanding of various trends in the stock market and the amount of the stocking and the companies that are listed in the stock exchange. Qualitative techniques helps to improve the overall quality of decision making approach.

Fundamental Analysis

The fundamental analysis is very useful in analyzing the various kinds of the stock and the prices of the stock market.” fundamental analysis is the process of looking at a business at the basic or fundamental financial level. This type of analysis examines key ratios of a business to determine its financial health and gives you an idea of the value its stock. Many investors use fundamental analysis alone or in combination with other tools to evaluate stocks for investment purposes” (Little 2010). The fundamental analysis tools are much useful in identifying the stock. There are various tools to analyze the shares of the company, which acts as a forecaster for the future growth and developments of the firm.

Stock Valuation

The stock valuation is a constructive technique in designing the values of the companies and the stocks. The method is much useful in predicting the future of the company and about the stocks, the various kinds of the pricing movements that will affect the firm, the value of the stocks that are different at different times and the stocks which are under valued that can be overvalued and sold. The stock valuation is mainly depended on the intrinsic stock and they are much useful in predicting the stock of the company. The fundamental analysis is the main tool for the identification of various stocks and that have certain marketing criteria. They depend on what they have to pay for the stock. These are mainly identified as the forecast for the cash flows and the profits which are together used in the stock market. The fundamental analysis of stock gives emphasis on various factors that are inherited in the stock market. They are mainly based on the fundamental criteria like the supply and the demand. It underlies the analysis of the stocks as the liquid shares and as the liquid reserves in the investment. There are various fundamental criteria in the stock market for the evaluation of the same. “Before he will consider a stock, a good analysis should be there to see the company’s earnings rising consistently for the last four or five years. He also needs to reassure himself that nothing has gone wrong recently, so he checks that the most recent quarterly earnings have shown growth compared to the same quarter a year ago. The upward earnings trend should be backed by a parallel sales trend. It is believed that earnings growth will not be sustainable if earnings are rising due to cost cutting rather than increased sales” (Zweig 2006).

The main stock evaluation methods are of two types. One method is mainly of the cash flow and the other is the fundamental analysis. In the cash flow method the investors usually sell the stocks, the main principle on which cash flow operate are the demand and the supply. As the fundamental analysis is considered, the fundamental valuation has to take place. The analysis is done as a prior step and the evaluation is done for the justification of the stock prices. The good example for these kinds of evaluations is the use of the methodologies like the P/E ratio, which denotes the Price to the total Earnings Ratio of the market. This kind of the evaluation method is depended on the past ratios which emphasis to give the values of stock in terms of finite attribute.

Above is the Composite price and P/E ratio of Shanghai. As is evident, the PE had dipped precariously during 2003- 05, but has since gained momentum, reaching around 52, which is a state which it enjoyed way back 2000- 2001. However, the aspect of investment gains (if included) needs to be deducted if the true P/E is to be realized. It is observed that growth rate in China and US have much in common; “however these two quantities have a countervailing effect on the P/E ratio. While a higher growth rate implies a higher P/E ratio, higher earnings volatility leads to a lower P/E ratio” (Huang & Wirjanto 2010, p.4). “In the presence of growth, the P/E ratio can be written as: P / E = (1+ g) / (k − g), where k is the cost of equity capital, and g is the growth rate. The U.S. experience is that k is about 7% and g is about 2%, so that the market-wide P/E is about 20. China’s GDP growth rate has been in the range of 7-9% in the past three decades” (Huang & Wirjanto 2010, p.4).

The alternate way of valuation is by the supply and demand. If more people are in need of the stock, the price will be higher and if there are more sellers in the stock trading arena, the price will be lowest. The forecast based on this method is not much worthy and it is useful only for a short period of time. ”The SUPPLY is the number of shares offered for sale at anyone one moment. The DEMAND is the number of shares investors wish to buy at exactly that same time” (Supply and demand, 2005). As there are numerous ways in the prediction and the valuation of the stock, the elementary ones are judged and only taken into account. The overall opinion of the stock is taken and certain evaluation techniques are specified.

EPS

The EPS of the company is the net income of the company and is a tool which helps in the analyzing of the earning per share of the individual and the company as a whole. ”An earnings per Share is the Net Income (profit) of a company divided by the number of outstanding shares. Earnings per share (EPS) tells an investor how much of the company’s profit belongs to each share of stock” (Earning per share-EPS, 2010).

EPS expand on basic EPS by including the shares of convertibles or warrants exceptional in the outstanding shares number. To calculate this number, apply the total incomes which do not include single gain and loss and the goodwill of the company. The EPS can be obtained by dividing the single shares.

The EPS helps in understanding the price to earning ratio and the different kind of the historical prices that are obtained by calculating the price to the earnings that are incurred. They are helpful as they replicate the future of the company.

PEG Ratio

This evaluation technique has in reality developed as an essential one. It is enhanced in checking the P/E because it considers certain factors like the price, earning of the share, and earnings according to growth rates. The presumption about the PEG ratio is as the ratios go; there is a percentage increase of over 100% of the stock that becomes very highly overestimated. When the PEG ratio has a decline below 100%, the stock happens to be much undervalued. The assumption is supported by the theory where the P/E ratios should be fairly accurate in the long-standing expansion rate of potential earnings of the organization. The theory if proven and will not uses the thumb rule in the entire evaluation process. “To calculate the Price Earning Growth Ratio or PEG Ratio, you need to take the P/E Ratio and divide it by the growth in the EPS. You can take an estimate of future earnings growth or an average of the past earnings growth. The conventional wisdom is that a PEG of greater than 1 indicates an overvalued company, and less than 1 indicates an undervalued company” (PEG ratio, 2009).

Return on Equity

One of the largest parts in the profitability evaluation criteria is the Return on Equity (ROE). Return on Equity discloses the level of profits that a company brings in, apart to the whole quantity of investor equity created on the balance sheet. The difference between the assets and liability is known as shareholders equity. Investor’s equity is a construction of accounting that symbolizes the assets formed by the maintained earnings of the business. “Return on Equity (ROE) is an accounting valuation method similar to Return on Investment (ROI).Because the numerator (Net Income) is an unreliable corporate performance measurement, the outcome of the formula for ROE must also be unreliable to determine success or corporate value” (Return on equity (ROE), 2010).

Discussions

Limitations of the Fama French Model in the CSM

This model cannot be used widely in companies. Studies conducted reveal that there is an argument regarding the size effect of a company that affects the stock returns. There had been many cases in which there is a contrast point regarding the concept that the size of the company affects the returns on the stock of the company. Another drawback of this Three Factor Model is that the book to market ratio of stocks is not very accurate as the company’s assets constitute both physical assets as growth opportunities. This mixture changes from time to time and thus it will not be able to portray the correct book to market ratio. The Fama French Three Factor Models can be widely used in the stock market as they focus the market return, the size effect of the company and the book value to market value of the stock.

The CAPM model states the relationship stuck between the risk and the obligatory rates of return on assets in expanded portfolios. The CAPM model is based on many assumptions like the evasion of transportation expenses and tax. In the CAPM model, all the focus is on a single holding period and the portfolio’s expected return and standard deviation is focused on a single holding period. Another assumption of this model is that all the assets are fixed in quantities. “The capital asset pricing model is based on balancing supply with demand among investors who have utility functions that convert units of consumption to units of satisfaction” (Shreve 2005, p.70). Fama and French while framing the Three Factor Model, has stated that every asset pricing model is a part of the capital asset pricing model. There have been many theories supporting the CAPM theories like the multiperiod asset pricing model, the capital asset pricing model with heterogeneous expectations and the arbitrage pricing model. “Earlier test of the simple single beta CAPM provided some support; later empirical work favors the more complex derivatives of CAPM in which multiple common factors explain much of the variation in asset returns” (Doherty 2000, p.151).

Expected Outcomes of Research

The Fama French Model has challenged the existing CAPM Model. It has laid down three tenets. The first one relating to beta, which assesses the market risks of stocks, the second one relating to the size of the company, assuming that if the risks taken by smaller companies are larger than that assumed by larger companies, its returns would also be larger. But, this does not necessarily have to be true, especially in the Chinese context; where there are a plethora of small firms which compete with larger ones, and yet do not have better earnings than larger ones. The third aspect is the ratio of book value as against its market value, or book value of shares/Market value of share. “Market value of equity is calculated by multiplying the company’s current stock price by its number of outstanding shares. A company’s market value of equity is therefore always changing as these two input variables change” (Market value of equity, 2010). Besides, while book value may be consisting of the paid up value of its shares and valuation in the financial books, the market value needs to take care of growth prospects of firm. In the Chinese context, it could be said that applying Fama and French theory would expound that there are basically two variables that consistently relates to stock returns, firm’s size and market/book ratio. Their studies show that, after adjusting for other factors; smaller firms are prone to higher returns that are relatively high on stocks with low market/book ratios. In much the same way, interestingly, Fama and French theory confronts orthodox CAPM Models, reaffirming that, everything said and done, a firm’s beta, (risk) has no correlation with future returns and both co-exist as independent entities. ”Tacit elements cannot be known and cannot be priced by reference to generic economy wide factors systematically affecting all firms and therefore appear as residual or unexplained risk in the empirical form of the CAPM” (Toms 1988, p.665).

According to the writings of Eugene F. Fama and Kenneth R. French in their famous journal entries called “The Cross-Section of Expected Stock Returns” it has been proved that their “tests do not support the most basic prediction of the SLB model, that average stock returns are positively related to market ßs” (Fama & French 1992. p.428).

Coming to the next question of whether the Fama French Three Factor Model could be used in the context of Chinese Stock Market. It is seen that the results have been positively encouraging. According to Zhang, Qianwen, M, “Based on the analysis, in the period of July 1995 to December 2004, the Chinese Stock Market s demonstrate (a) size effect, (b) book-to-market equity effect, (c) earnings-price ratio effect, (d) dividend yield effect, and (e) past stock price effect. Then, this thesis testifies that the Fama-French three-factor model can capture the cross-sectional variation in returns of portfolios formed on those five variables mentioned above for the 1995-2004 period” (Authentication error, 1976).

Thus, since the Chinese Stock Market is burgeoning, it is quite possible to identify and analyse the book- to-market equity effect which is the keystone of the Three Factor Model. Besides, China has been identified as the most growth oriented country in the world, not only in Asia but also in the world. This would definitely work positively towards achievement of high book market ratios for small firms.

On the other side, it is also seen that the Chinese Government enforces a strict vigil on the performance of businesses, and most firms and enterprises operating in this country need to obey the governmental corporate laws and structures very strictly; failing in which they would even have to face censure, fines and even dissolution of business. Thus, in the context of the direct intervention of Chinese government in the internal management of corporate, big and small, the Fama and French Model could be appropriated in the Chinese context is a matter of concern and supreme conjecture. Besides, it is also seen that the Chinese Government also hold stakes in the form of shareholdings or other stakeholder interests in large and SME’s by virtue of lending capital or asset resources, like land, machinery, etc. Under such circumstances, the best Fama and French Model could act under such situations in a matter of concern, especially in movement of stock prices. Chinese corporate sector is highly segmented and fragmented.

There are only two stock exchanges in China. They are Shanghai Stock Exchange and Shenzhen stock exchange. Shanghai established in December 1990 and Shenzhen established in July 1991. Whereas Shanghai SE deals with big companies, Shenzhen SE deals with lesser firms and SME’s.

One of the most critical and significant factor about Fama and French Model is that it tests book to market (BM) ratios. This is useful in the determination of explaining cross section of the expected stock results. The studies carried out by the Fama and French Models ascertained the stock returns that are negatively related in the case of market size and positively connected in the case of BM ratio. In the context of Chinese Stock Exchange characteristics, it is also deemed that the Government companies or SOE’s were not well managed and often, it had to pass hands to private investors, who perhaps could manage them better. Another interesting factor about Chinese Stock Exchange controlled companies is that geography and location play important roles. But, it must be said that the growth of Chinese economy has been awesome and a model for other developing countries. For illustration, during 1991, there were 13 “listed companies” with “market capitalization” of RMB 10,913, during 2002, that is within a span of just 11 years or so. The listed companies reached an incredible 1227 firms with a whooping “Market Capitalization” of RMB 30,729.07. (Chen et al 2007). “The results suggest that the risk variables may contain some information, which is captured by size and BM variables. By replacing size and BM with risk variables, we can better explain risk nature and also provide better information for management to control the risk. “The results also indicate that size is negatively significant and BM is positively significant in most time periods at 5% level. For the whole sample period average values, the size and BM are significant at 1% level. The results are consistent with the US market (Fama and French, 1992)” (Chen et al 2007).

Does Frequent Trading Impact upon Stock Prices

The results of these conducted studies regarding the Chinese Stock Market shows that there are consistencies and harmony with previous studies for both size and BM ratios. That is, it validates previous studies that Market risk, or beta; following the path of being positively correlated with Market size and negatively with book market risks. Besides, “The results also show that another risk factor not included in the size and BM variables is related to returns. The risk factor is about the company’s intangible asset ratio. We found that higher intangible asset firms are usually associated with higher return rate” (Chen et al 2007). Further, “on average, individuals hold roughly one-third of shares outstanding, with the remaining two-thirds (largely non-tradable shares) held by the government entities” (Eun & Huang 2002, p.5).

In the Chinese Stock Market context, stock prices are based on total risks, and not market risks. Investors in China do not wish to diversify their portfolios of various known and unknown reasons like limitation of invest able funds, lack of proper market knowledge, lack of access to mutual funds, etc. Investors in the Chinese context believe in liquidity of their holdings, and thus they are keen about liquid funds as much as is possible. Under such a situation, the question of capital gains tax assumes importance and prominence, since they are more interested in easy money. Thus, while assuming that the bourse remains static; it is quite possible that the governmental control could act adversely to stakeholder interests, especially in terms of returns and dividend payouts. Nevertheless, typical Chinese market force factors do play upon the investors’ mind and their investing capacities.

As mentioned earlier, the industry framework in China is fragmented and involves large players, big and small. The influence of government also plays a role; albeit positive, in governance of stock markets and role of business houses in the economic order.

However, it should be stated that the Chinese governmental attitude to business has undergone conspicuous changes since the “opening of the economy” in the late 1980s. Fundamentally, when considering Fama and French Three Point Theory, “There are three stock-market factors: an overall market factor and factors related to firm size and book-to-market equity” (Fama & French 2002).

The Chinese administration, including economic think tanks have realised, albeit late, that China cannot grow in a secluded and closed economy and it took its first tentative steps towards globalisation and opening up its economy. In the context, it is also relevant to mention about the findings of the research on returns of stock and bonds conducted by Fama and French, which was published in the Journal of Financial Economics,Vol.33,1993, 3-56, under the title of ‘Common Risk Factors in the Returns on Stocks and Bonds.’ “The basic assumptions of this study have been on similar lines, in that it has BM ratios (Book Market Ratios) that could vary vis-à-vis stock returns. Thus, firms have high BE/ME (how stock price compares with market price) would have lower earnings as compared to firms having comparatively low BE/ME, that is market value being higher than its book valuation. The trends need to be analysed considered a period, five years prior to BE valuation and five years post, BE valuation” (Fama & French 1993).

Thus, the results of these studies on Chinese Stock Market does prove that beta, or risk is not dependent on book –market value and also high returns does not necessarily mean that risks are high and vice versa. Beta is considered as an independent unit in as far as stock modelling is concerned. Fama and French does not have the financially theory support in the variable effect to return rate and risk of both variables and return rate. Again, under empirical studies; it is seen that the Arbitrage pricing theory is also useful in the context of stock valuation for oil industry.

“The Arbitrage Pricing Theory (APT) was developed primarily by Ross (1976a, 1976b).It is a one-period model in which every investor believes that the stochastic properties of returns of capital assets are consistent with a factor structure. Ross argues that if equilibrium prices offer no arbitrage opportunities over static portfolios of the assets, then the expected returns on the assets are approximately linearly related to the factor loadings” (Huberman & Wang 2005, p.2). Again, “Fama and French Model has limitation in general and difficult in procedure effect to Fama and French Model not popular compare with CAPM Model.

This research can be developed by studying Fama and French model to compare with other models as APT model. Not only that, it can study by adding the other variable or factors as factors about debt, assets, P/E ratio into Fama and French Three Factors model” (Homsud et al 2009, p.9).

Besides, another aspect of the context of Chinese market book valuation would be the gaining of correct values for the dissertation. Theoretically, Fama and French may look very appealing on paper. The extent to which it would be able to produce accurate results without proper data is indeed a matter of concern and conjecture. In the changing economic scenario, many new theories like F &F , or even improvements on the authors’ earlier research studies could be seen and this need to be put to good empirical use.

Anticipated Limitations of Study

The correct measurement of the data and correct mathematical design is important in a research study of this kind, especially in the context of highly fragmented and divisive study. The possibilities of errors or bias needs to be ruled out and a non- discriminatory, objective and result oriented study needs to be conducted.

The Chinese Stock Market itself is fragmented with several big and small players and thus the matter of valuation of beta or risks may not be an easy task by any standards and may depend upon a host of factors, direct and indirect. Besides the data, the interpretation and findings of Fama and French may involve a study of complex statistical diagrams that are also a bit difficult for new customers or novice researchers. “The Arbitrage Pricing Theory (APT) was developed primarily by Ross (1976a, 1976b).It is a one-period model in which every investor believes that the stochastic properties of returns of capital assets are consistent with a factor structure“ (Huberman & Wang 2005, p.2). Besides, a typical Chinese investor is rather risk averse and would look more towards capital appreciation rather than quick returns. Under the present circumstances, this is indeed necessary since best part of the economic world is just recovering from series of crippling depressive cycles and unprecedented economic recession. Under such situation, Chinese stock exchange is also leery about new high risk investment options, especially in new or growing companies. How this impacts F&F is in terms of the fact that given that this Model disputes the claim that risk is commiserative with market returns, the average Chinese investor would not place risks, in new and nascent companies. This would definitely set negative vibes in the bullish movement of stocks in Shanghai and Beijing Stock Exchange. There are many impacts in various investment proposals for the growth and prosperity of Stock exchange and its member companies, but by far, what could create most impact could be use of Models for identifying, assessing and implementing tools for deciding future business trends.

It is believed that considering the complete and varied calculations concerned with the use of F & F in the Chinese context; the economy of which is dynamic, volatile and highly competitive with the government also playing a good role in business in terms of investments and holdings This is because the Government have invested heavily in PSU and public -private enterprise, and almost 33% of investments are the ones in which the government is involved; directly or indirectly through shareholdings, directorships or otherwise.

One of the major limitations could also be in terms of the fact that detailed data collection, collation and interpretations are required for placing Fama and French Model in the context of Chinese Stock Market movements, especially in the case of capital gains. Besides, the choice of the sample population, its deliberations and interpretation using tried models are also important considerations required for a research that needs to be carefully carried out. Both the APT and the Fama & French Three Factor Model have evolved as arguments against CAPM, and are basically held in order to reduce the potency of the former. Under these theories, unsatisfactory bourse performances by stocks are temporary, as is good performance which may not last long under Chinese market conditions. Similarly, companies that continue to perform well do so, at least on short to medium term. The Chinese context, for instance, shows that a low book-market value shares do not do well; but high indexes may do well consistently.

While the Chinese markets are conservative, they do not respond well during crises. Under such circumstances, it becomes necessary to consider the long term values. Next it becomes necessary to draft a time table for the research. The items mentioned under individual weeks present a rough time span which may change because of certain superimposing circumstances. There may also be instances of changes in the timetable to accommodate new and unexpected items. “This implementation timetable gives external stake holders information about the likely content and timing of future research competitions and calls for proposals” (Search research database document record, 2008).

Conclusions

Now, it is necessary to come to the validation part of this research study. The Chinese Stock Exchange has been of comparatively recent origin, and yet it has been able to account for extra-ordinary performance beyond its life span. As the major pillar and source of economic and financial strengths for this country, it has carried out its duties and responsibilities remarkably well. This is evident from the massive surge in the industrial growth which is expected to touch 25% annual growth rate. Besides, although the industrial scenario has been polarized between large private Chinese MNC’s having excellent profitability growth prospects. On the other hand, we have government companies which are in the red, and also Small and Medium Industries (SME) and State Run Units (SRU) which are not doing particularly well. This unsustained and fragmented growth of Chinese markets also reflects in its share performance, since the stock rates truly reflect the health of industrial units; big and small. Besides, “The robustness of the model is also checked for two effects: up- and down-market conditions and seasonal behavior” (Lam et al 2009).

Coming to the aspects of Fama and French (F & F) theories in the context of Chinese bourse, it could be said that they could be applied since these respond to the choices provided by this theory in the Chinese context. For one thing, the Fama and French theory upholds the fact that beta (risk) cannot be linked with investment returns, and this has been amply demonstrated in the Chinese context. Many small Chinese firms are doing as well, if not better than their larger counterparts. Again, coming to BM (book market) studies, it has been proved that high BM means lower returns and low BM means high returns in the Chinese bourse stock movements.

Besides, “The insignificant differences in forecasting accuracy at the very least prove that the liquidity-based models are compatible with Fama-French model” (Rahim & Mohd. Nor 2006, p.16). It is necessary to know how F&F could help promotion of stock exchange activities in China. “There are two separate messages to take away from this. First, the three factors together account for practically all of a portfolio’s behavior; that’s the strongest evidence yet that mutual fund can’t beat indexes. Second, history indicates that small value “just happens” to deliver higher returns and higher volatility than the stock market as a whole” (Fama and French three factor model, n.d).

Finally, coming to the question as to whether asset pricing models are well set in the Chinese context, it would be too early to say yes; considering that the investment climate has been skewed and is not much of fresh investments in risky sectors are underway. For one thing, most Chinese investors are risk averse and they would rather believe in safety and security of their investments rather than quick cash returns which may not sustain for long. Besides the present economic scenario, low demand for products and services, lack of growth in core areas like housing, investment and portfolio banking and the government attitude and control over business enterprises etc play a significant role in dampening investor spirits.

In retrospect, “our main finding is the size risk premium that in China stock market is very significantly and book-to-market risk premium also is significantly but not as strong as size. This is consistent with many evidence of Fama–French examination of other country” (Zeng n.d).

There have been many issues arising out of the French and Fama Model and yet, it has sustained over testing times and changing business scenarios. For one thing, it has been used where conventional CAPM methods cannot be effectively utilized and also proved its mettle in the Chinese context. What sets it apart could be its ease of operation and the fact that it is a composite whole and does not really depend upon conventional tools. Given the fact that F & F could be used in the context of Chinese stock market, what remains to be proved is with respect to its scope and its modus operandi. Given the fact that book market values do not really dictate market returns and also need to be separately considered, the scope and onus of F&F Three pronged model indeed has its enduring value and could be applied in bullish markets. However, it needs to be seen on a case to case basis, disallowing the fact that it could not be on blanket basis, covering various aspects. What is even more important is that the long term implications of using and implementing the fallouts of F&F Model needs to be anticipated and forecasted, and how use of F&F could impact upon future economic studies and corporate conduct also needs to be known. It is necessary that a complete probe of F and F with its ramifications need to be done before a final decision regarding its implementation or not be taken, on case to case basis. The long term perspective of investment decisions, except for casual traders need to be considered if the right and judicious implementation of the F& F Model for the Chinese stock exchange need to be considered.

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