An Empirical Test of CAPM: Evidence

from Shanghai Stock Exchange 2001-2005

by



Xinxin Wu

2006








A Dissertation presented in part consideration Ior the
degree oI MA Investment and Finance
2
ABSTRACT

As a Iinancial theory, the Capital Asset Pricing Model (CAPM) has dominated the
academic literature and inIluenced greatly the Iield oI Iinance and business in practice
over Iour decades. This dissertation examines the validity oI the CAPM in the Shanghai
Stock Exchange (SSE) which is one oI the two stock exchanges in the mainland China
Ior the period Jan 2001Dec 2005. Employing the approach proposed by Fama and
MacBeth (1973) with modiIications suggested by Pettengill et al. (1995), I reach a
conclusion that is inconsistent with Fama and MacBeth (1973)`s Iinding as the
unconditional CAPM is not valid in the SSE, while conditional CAPM is inapplicable
either since there only exist weak insigniIicant beta-return relationship. Using beta as the
only proxy Ior risk is questionable. In addition, aIter comparing the empirical SML with
the theoretical SML under the conditional CAPM, the slope oI the relationship between
realized return and beta is less than that oI the relationship between expected return and
beta predicted by the CAPM with the SML is steeper positively in up market and Ilatter
negatively in down market. In general, the CAPM does not hold in the Chinese stock
market.





3
TABLE OF CONTENTS Page
ABSTRACT..................................................................................................................2
ACKNOWLEDGEMENTS ........................................................................................5
LIST OF TABLES........................................................................................................6
LIST OF FIGURES .....................................................................................................7
CHAPTER 1 INTRODUCTION.............................................................................8
1.1 Research Objectives.........................................................................................8
1.2 Research Methodology ....................................................................................9
1.3 Dissertation Structure.....................................................................................10
CHAPTER 2 LITERATURE REVIEW...............................................................12
Introduction..........................................................................................................12
2.1 The CAPM Theoretical Background .............................................................12
2.1.1 The Development oI the CAPM Equation............................................................12
2.1.2 The Security Market Line....................................................................................15
2.1.3 The CAPM Assumptions .....................................................................................16
2.2 Prior Empirical Surveys.................................................................................18
2.2.1 Early Empirical Evidences Irom the US Markets ................................................19
2.2.2 Empirical Evidences ThereaIter ..........................................................................20
2.2.2-1 Positive Evidence aIter 1970s in the US Markets .....................................21
2.2.2-2 Debates against the CAPM......................................................................21
2.2.2-3 DeIence oI the CAPM .............................................................................26
2.2.2-4 Evidences Irom Other Developed Markets...............................................31
2.2.2-5 Evidences Irom Emerging Markets ..........................................................36
Conclusion ...........................................................................................................40
CHAPTER 3 THE CHINESE STOCK MARKET AND ITS MARKET
INSTITUTIONS.........................................................................................................41
Introduction..........................................................................................................41
3.1 The Chinese Stock Markets ...........................................................................41
3.2 Market Institutions.........................................................................................42
3.1.1 A and B Shares....................................................................................................43
3.1.2 Listing Procedure and Market Exit Mechanism....................................................45
3.1.3 Typical Characteristics oI Chinese Stock Markets ................................................47
3.3 The Shanghai Stock Exchange (SSE) ............................................................49
Conclusion ...........................................................................................................51
CHAPTER 4 EMPIRICAL TEST OF THE CAPM............................................53
Introduction..........................................................................................................53
4
4.1 Data and Methodology...................................................................................54
4.1.1 Data Collection ...................................................................................................54
4.1.2 Methodology.......................................................................................................56
4.2 Empirical Test Results and Discussions.........................................................63
4.2.1 General Findings .................................................................................................63
4.2.2 Regression Analysis ............................................................................................69
4.2.2.1 The Unconditional Relationship................................................................70
4.2.2.2 The Conditional Relationship....................................................................74
4.2.3 Security Market Line (SML) Analysis .................................................................79
Conclusion ...........................................................................................................84
CHAPTER 5 SUMMARY AND CONCLUSION................................................86
BIBLIOGRAPHY......................................................................................................90
APPENDIX 1: Data oI 80 Listed Securities and Market Index ...............................97
APPENDIX 2: The Unconditional Regression Test Results ....................................99
APPENDIX 3: The Conditional Regression Test Results ...................................... 102
APPENDIX 4: The Theoretical Test Results Ior the Conditional Relationship
between Expected Return and Beta ........................................................................... 105












5
ACKNOWLEDGEMENTS

I would like to give my gratitude to my supervisor Dr Ghulam Sorwar, Ior his guidance,
support and encouragement throughout the process oI this dissertation.

Further, I would like to express my appreciation to my parents and Iriends, with their
consistent love and support; I Iinally Iinish my one-year MA study.
















6
LIST OF TABLES
Page
Table 3.1 Tradable A-shares in both SSE and SZSE 44
Table 3.2 The SSE Trading Summary Ior the Year 2005 50
Table 4.1 PortIoliosTotal Sample Period 66
Table 4.2 Unconditional Test ResultsStocks 70
Table 4.3 Unconditional Test ResultsPortIolios 72
Table 4.4 Conditional Test ResultsPortIolios 75















7
LIST OF FIGURES
Page
Figure 1.1 Security Market Line 15
Figure 3.1 Historical Trend oI the SSE Index 51
Figure 3.2 Trend oI the Movement oI the SSE Index 51
Figure 4.1 Realized Return and Stock STD (Total Period) 64
Figure 4.2 Realized Return and Stock Beta (Total Period) 64
Figure 4.3 Realized Return and Stock Beta (1
st
Sub-period) 65
Figure 4.4 Realized Return and Stock Beta (2
nd
Sub-period) 65
Figure 4.5 Realized Return and PortIolio STD (Total Period) 66
Figure 4.6 Realized Return and PortIolio Beta (Total Period) 67
Figure 4.7 Realized Return and PortIolio Beta (1
st
Sub-period) 67
Figure 4.8 Realized Return and PortIolio Beta (2
nd
Sub-period) 68
Figure 4.9 Realized Return and PortIolio Beta in Up and Down Market 76
Figure 4.10 Expected Return and PortIolio Beta in Up Market 80
Figure 4.11 Expected Return and PortIolio Beta in Down Market 80
Figure 4.12 Theoretical SML and Empirical SML in Up Market 82
Figure 4.13 Theoretical SML and Empirical SML in Down Market 82





8
CHAPTER 1 INTRODUCTION

1.1 Research Objectives
The Chinese economic reIorm and open door policies implemented since 1978 has given
rise to the establishment oI the Chinese Stock Market in the early 1990s, which then is
expanding dramatically year by year. As one oI the most important emerging markets
around the world, the Chinese stock market has attracted many researchers Irom diIIerent
perspectives with diIIerent approaches.

The Capital Asset Pricing Model (CAPM) developed by Sharp (1964), Linter (1965) and
Black (1972) has been one oI the dominant capital asset equilibrium models in Iinance
theory. The CAPM Iocuses on the relationship between systematic risk and expected
return oI assets with the central tenet that systematic risk as measured by beta is the only
Iactor that accounts Ior return required by completely diversiIied investors. In addition, as
Peasnell (1986) indicated, the CAPM has been utilized in great variety oI ways Ior
diIIerent purposes.

Nevertheless, in general, empirical tests Ior the CAPM model has mainly emphasised on
three implications: the intercept is equal to the risk-Iree rate oI return; there exists a linear
relationship between risk and return; and the market risk premium is positive.

This dissertation will carry out an empirical test oI the CAPM in Chinese stock market,
aiming to provide some contributions regarding to the relevant literature since most
9
CAPM researches have been Iocused on the US or other developed markets in Europe.
International markets especially the emerging markets in Asia have received considerably
less attention. In particular, there are very limited literatures exist in respect to the
applicability oI the CAPM in China stock markets.

However, due to time constraint, this study puts attention to research one oI the two stock
exchanges in the Mainland Chinathe Shanghai Stock Exchange (SSE) on the basis oI
relevant theories and academic Iindings. It examines beta-return relationship in the SSE
in order to assess the applicability oI the CAPM in Chinese stock market, while the
Security Market Line (SML) oI the SSE can be drawn and considered thereaIter.

1.2 Research Methodology
Data collection and calculation is the most important part oI this study. In this dissertation,
Shanghai Stock Exchange (SSE) will be used as the research scope due to the reason that
it is the largest and representative stock exchange in the mainland China. Its research will
be helpIul to give the indication oI the applicability oI CAPM in Chinese stock market.
The data used in the dissertation consists oI the randomly chosen closing stock prices and
the SSE Index value based on 5 years/60 months Irom January 2001 to December 2005.
All data can be taken Irom the Stockstar Exchange SoItware and the database oI the SSE.

In general, the methodology used in this dissertation is a two-step regression model that
is Irom Fama and MacBeth (1973), with modiIications suggested by Pettengill et al.
(1995). The Iirst step involves using a regression model
it i t t it
e R + + = |
1 0
to examine
10
the unconditional approach oI the beta-return relationship. The test oI this model is based
on the mean oI the coeIIicients oI the monthly regressions. II the realized return is more
than the risk-Iree interest rate with a signiIicant t-statistic, a positive unconditional
relationship between beta and return is supported, which provides important implications
concerning empirical test Ior a systematic relationship between beta and return.

The second step involves using the cross-sectional regression model
it i t i t t it
e D D R + + + = | | ) 1 (
2 1 0
to examine the conditional relationship between
beta and return, where there should be a positive beta-return relationship when the excess
market return is positive and a negative relationship when the excess market return is
negative. The above model can be tested by the standard t-statistic using hypotheses test.
II conditional CAPM is valid, a systematic conditional relationship between beta and
realized return will be supported and the null hypothesis should be rejected. AIter
evaluating the results Irom both unconditional and conditional analysis, the relationship
between risk as measured by beta and return will be shown by the SML.

1.3 Dissertation Structure
This paper is organized as Iollows:

Chapter 2 covers the literature review oI this study so that to establish the academic
Ioundation Ior the empirical test. It includes empirical evidences in respect to the CAPM
Irom both developed markets and emerging markets. In particular, debates against the
CAPM, deIence Ior the CAPM will be discussed.
11
Chapter 3 introduces and considers the Chinese stock market and its market institutions.
The purpose is to provide background knowledge in order to help to understand the
diIIerences between the china stock market and other developed markets.

Chapter 4 includes the empirical test oI the CAPM. Data collection, methodology and
results Irom both general Iindings and regression analysis are described and examined.

Finally, Chapter 5 provides the summary and conclusions Ior this study. Limitations oI
this dissertation, especially Ior the empirical test results will also be considered in this
chapter.













12
CHAPTER 2 LITERATURE REVIEW

Introduction
In respect to the literatures regarding to empirical test oI the CAPM, many researchers
have already engaged the relevant study in Iinancial markets in diIIerent countries. In this
chapter, aIter summarizing the CAPM theoretical background, past studies will be
reviewed by dividing them into three sections: early empirical evidence Irom the US
markets, empirical evidence Irom both the US and other developed markets thereaIter,
and Iinally, empirical results Irom emerging markets, especially the Asian markets.

2.1 The CAPM Theoretical Background
As a Iinancial theory, the capital asset pricing model (CAPM) has dominated the
academic literature and greatly inIluenced the Iield oI Iinance and business in practice
over Iour decades. The attraction oI the CAPM is not only accounted Ior its powerIul and
intuitive predictions about how to measure systematic risk and the relationship between
expected return and risk, but also accounted Ior its simplicity and convenience in use.

2.1.1 The Development of the CAPM Equation
Prior to the development oI the CAPM, in the 1950s, Harry Markowitz`s (1952)
diversiIication and modern portIolio theory argues that aIter considering the co-
movements oI each stock with all other stocks, a better portIolio could be constructed that
had the same expected return but less risk than a portIolio being constructed by ignoring
the interactions between stocks. James Tobin (1958) Iurther developed conditions under
13
which Markowitz`s mean-variance theory could be optimal. Tobins` separation theorem
shows that in order to be optimal, each investor should only hold eIIicient risky portIolio
and the risk-Iree asset. However, the theory oI Markowitz and Tobin could not be
implemented at that time because it requires the inversion oI the covariance matrix oI
returns among all securities under consideration, which was an impossible task Ior that
period due to the limited computing power. (Das et al. 2002)

In the 1960s, William Sharp (1964) developed a pioneering achieving index model-the
Capital Asset Pricing Model (CAPM) which eIIectively solved this practical problem.
Given the condition that all investors Iollow Markowitz`s mean-variance approach, the
expected return on a security will be positively and linearly related to the class oI its
market beta, where the systematic risk should be directly related to the expected return
under the situation oI market equilibrium. That is, the higher (lower) a security`s beta the
higher (lower) its expected return. Moreover, Mossin (1966) conIirmed the existing oI the
security market line and emphasized the importance oI market equilibrium. Lintner (1965)
and Black (1972) observed that the market portIolio oI risky securities is mean variance
eIIicient, which implies that the market beta should be the only proxy Ior the security`s
risk. Further, Black (1972) developed a more general version oI the equilibrium expect
return-beta relationship as he releases the restrictions on risk-Iree investments, where the
risk-Iree asset is replaced by a portIolio that has the minimum variance oI all portIolios
uncorrelated with the market portIolio.

Based on the Iindings oI Sharp (1964) and Lintner (1965), Black (1972) derived the
14
capital asset pricing model (CAPM) under conditions oI market equilibrium as Iollows,

| ) ( | ) (
f m i f i
R R E R R E + = | (1)

Where ) (
i
R E - the expected return on asset i Ior the period is the return on the risk Iree
asset (
f
R ), plus the risk premium on the market | ) ( |
f m
R R E , times the risk on the
asset relative to the market (
i
| ).
i
| is the sensitivity oI asset i to the market movements
and the slope oI the regression line between
i
R and
m
R , in which could be deIined as the
ratio oI the covariance (or co-movement) oI returns on asset i and the market portIolio m
to the variance oI returns oI the market portIolio.


2
,
) (
m
m i
i
R R Cov
o
| = (2)

The above expected return and beta relationship is the most Iamiliar expression oI the
CAPM, and, in addition, because oI the joint eIIorts oI three economists (Sharp, Lintner
and Black); the CAPM equation is also called the Sharp-Lintner-Black (SLB) model.

Moreover, in respect to the deIinition oI beta, Brealey and Myers (1999) made a
considerable and composite description by classiIying the level oI risky investment. The
least risky investment such as bond or treasury bills, have a beta oI zero. The market
portIolio oI common stocks have an average beta oI one as the aggressive stocks have a
beta value more than one and the deIensive stocks have a beta value less than one.
15
2.1.2 The Security Market Line
Using beta as a measure oI systematic risk, the beta-return relationship on an asset can be
represented by the Security Market Line (SML). The CAPM indicated that the expected
risk premium should change sensitively with beta, all investment must plot along the
SML connecting the bond or treasury bills and the market portIolio, and the average
stock returns are positively related to the beta. The SML demonstrates that the expected
return to any risky assets or portIolios is the sum risk premium determined by the value
oI beta and the risk Iree rate.

The Security Market Line (SML) can be expressed as:

Figure 1.1: Security Market Line


According to the mean-variance theory, Richard Roll (1978) indicated that the SML
analysis interprets deviations in expected return Irom the SML above or SML below. All
assets and risky portIolios should lie on the SML ex ante, meanwhile, all oI the ex post
E
x
p
e
c
t
e
d

R
e
t
u
r
n

m
R
f
R
Security Market Line
Systematic Risk (Beta)
16
deviations Irom the SML are caused by statistical estimation errors. The ex ante SML is
based on the ex ante expected return at the beginning oI the year, but the ex post SML is
drawn in accordance with the actual return at the end oI the year.

2.1.3 The CAPM Assumptions
A number oI important and Iundamental assumptions were made Ior the simplicity oI the
CAPM, and guarantee a single optimal risky portIolio and the unique trade-oII between
risk and return Ior all investors, they are:

1. Investors are all risk-averse and rational mean-variance optimisers, which mean they
all use Markowitz portIolio selection model.
2. All investors have identical subjective estimates oI the means, variances, and
covariances oI return among all assets, that is, investors have homogeneous
expectations and perceive identical opportunity sets.
3. All investors can borrow or lend an unlimited amount at a given constant risk-Iree
rate oI interest
f
R .
4. All investors have common investment horizons.
5. All assets are perIectly divisible and priced in a perIectly competitive market.
6. The capital market is perIect, and thereIore, (1) InIormation is costless and
simultaneously available to all investors; (2) There are no transactions costs, no taxes
or any other market Irictions; (3) All investors are price takers, that is, no single
investor can aIIect the security price Irom buying or selling activities.
7. The market is in equilibrium and there is a deIinite number oI assets and their
17
quantities are Iixed within the one period world. That is, the total quantity oI risky
securities that investors want to buy is equal to the total quantity that other investors
want to sell.

However, the above assumptions that underlie the CAPM model are restrictive and
unrealistic, release these assumptions could lead to a diIIerent perspective and result. For
example, release assumption 2 and 6 would result in investors to have heterogeneous
expectation in terms oI their expected return, and hence choose their own eIIicient
Irontier with diIIerent market portIolios because oI inIormation asymmetry or transaction
costs or diIIerent time horizons. Further, iI assumption 3 is violated due to the restriction
oI borrowing, the lending-borrowing line would intercept at diIIerent points on the
eIIicient Irontier. Nevertheless, only when the market is in equilibrium, all risky assets
will be included in the market portIolio, and hence guarantee the mere choice Ior
investors to hold a combination oI risk-Iree assets and market portIolio in accordance
with their utility Iunction.

In reality, investors have their own risk preIerences, and may be risk-loving instead oI
risk-averse. In other words, investors may have a preIerence Ior risk, and may have a
discontinuous utility curve. Moreover, it is impossible Ior investors to have identical
expectations because oI the diIIerent levels oI inIormation, Ior instance, institutional
investors and individual investors. Institutional investors have some degree oI advantage
compared to individual investors as they may have inside inIormation and may have the
power to aIIect share prices. Investors are not likely to use the same lending and
18
borrowing rate as well, because lenders need to make money Irom lending and borrowers
have to pay a deIault premium rate. The investment horizons Ior investors are also
diIIerent as investors may choose their horizons that tailored to their individual needs.
Young couple may preIer risky investment such as stocks and derivatives in order to earn
great excess return to satisIy their huge expenses, whereas retired people may preIer bond
or treasury bills as they have settled well and do not expend a lot. Finally, the capital
market is imperIect. InIormation is not costless and simultaneously available; there are
only limited numbers oI public reports; insider trading exists not only in developing
markets, but also in developed markets; all investors pay taxes and transaction costs Ior
their trading in securities.

However, although these assumptions are strong and unrealistic that deviate Irom the
reality, as Xu (2001 cited in Diacogiannis, 1993, p316) the Iinal test oI a theoretical
model is not how realistically its assumptions reIlect the real world but how well the
model Iits real data.` ThereIore, the validity oI CAPM can only be established through
empirical tests.

2.2 Prior Empirical Surveys
AIter the CAPM model was provided, researchers and scholars have made various
empirical tests in order to provide evidences, or doubts and arguments. According to Xu
(2001), empirical tests oI the CAPM have generally Iocused on three implications oI
Equation (1): Firstly, the intercept should equal the risk-Iree interest rate; secondly, beta
is the only proxy Ior the security`s risk which completely captures the cross-sectional
19
variation oI expected returns and the beta-return relationship is linear; Iinally, the market
risk premium is positive.

In this section, prior empirical studies on the CAPM Irom both developed markets and
emerging markets will be reviewed. Overall, it seems that previous empirical studies have
not provided the consistent results yet. Early empirical results are generally positive that
support the CAPM model. In contrast, evidences thereaIter seem not to support it too
much, because chosen beta as the only proxy Ior risk is in doubt.

2.2.1 Early Empirical Evidences from the US Markets
Since the CAPM was developed in the 1960s, enormous amount oI literatures presenting
empirical evidences on it has evolved Irom the United States, in which also dominant the
literatures on testing the CAPM. Early tests oI the CAPM were conducted within a single
country-the US, and were concentrating on the data prior to 1969.

Black, Jensen and Scholes (1972) concluded that their test results oIIer a strong support
Ior the CAPM model aIter analyzing the returns on portIolios oI securities at diIIerent
levels oI beta Irom the period 1926-1966. They Iound that in general there is a positive
simple relation between average return and market beta using NYSE market data. Both
Blume and Friend (1973) and Fama and Macbeth (1973) reported similar Iindings. Blume
and Friend (1973) indicated the linearity oI the relationship between risk and return Ior
NYSE stocks over three diIIerent periods aIter the Second World War using the similar
NYSE market data Irom the Centre Ior Research in Security Price (CRSP) and
20
COMPUSTAT during the pre-1969 period. Fama and MacBeth (1973) Iound a
signiIicant average market excess return oI 1.30 per month and suggested a positive
relationship between beta and monthly returns as well. They acknowledged that the result
can not reject the SLB model hypothesis, and there should be a linear relationship
between risk and return implied by the model; and more importantly, no measure oI risk
in addition to beta systematically aIIects average returns. In addition, Fama and MacBeth
(1973) introduced the two-pass regression approach (FM approach) Ior the Iirst time on
testing the CAPM, which later becomes a dominant methodology in the empirical test oI
the CAPM literature.

However, despite the strong positive empirical results, negative evidences that against the
CAPM model were still exist. For instance, researchers have Iound that the estimated
intercept indicates a higher risk-Iree return than the one used as input, and hence, iI
illustrating the result with the security market line, the slope oI risk-return trade-oII
would be insuIIicient steep. (Xu, 2001) Nevertheless, Black (1972) provided two possible
reasons Ior this deviation: one is because the use oI a proxy instead oI the actual market
portIolio, and the other is that there may be no real risk-Iree asset exists and the CAPM
does not predict an intercept oI zero.

2.2.2 Empirical Evidence from the US and Other Developed Markets Thereafter
From the late 1970s, empirical tests Ior the CAPM provided mixture results. Especially in
recent 30 years, less Iavourable evidences come in a continuous stream; many researchers
suggested various arguments against the SLB model. This section Iirst gives a summary
21
in which researchers still Iound positive evidences in respect to the US markets. Then
debates against the CAPM will be discussed, Iollowed by the deIence Ior the CAPM
challenged by the CAPM deIenders. Finally, evidences Irom other developed markets
will be considered.

2.2.2-1 Positive Evidence after 1970s in the US Markets
Dowen (1988) analyzed iI a security`s price is only determined by beta because all
unsystematic risk would be eliminated by the diversiIication. Although he concluded that
there is no suIIiciently large portIolio could guarantee the elimination oI non-systematic
risk, his results still in Iavour oI the CAPM, and Iurther suggested that portIolio managers
may use beta as a tool but not as their only tool. Kothair et al. (1995) made a re-
examination oI the risk-return relation using a longer measurement interval returns and an
alternative market data the S&P industry portIolios on the basis oI the research Irom
Fama and French (1992). They presented evidence that average returns do indeed reIlect
substantial compensation Ior beta risk, provided that betas are measured at the annual
interval.` (Kothair et al. 1995) Furthermore, Jagannathan and Wang (1996) also agreed
with the SLB model, oIIered a support Ior a positive relationship between return and beta
as they assumed that the CAPM holds in a conditional sense with the beta and market risk
premium vary over time, and thereIore, conIirmed the validity oI the CAPM.

2.2.2-2 Debates against the CAPM
Reinganum (1981) who Iollows the methodology oI Fama and MacBeth (1973), however,
have got diIIerent test results. In a sample oI daily returns, he Iound that the portIolio
22
return decreases when beta increases. In contrast, he discovered that there is a positive
relation exists between return and beta in the sample oI monthly returns. Reinganum then
concluded the insigniIicant oI the diIIerence in returns across portIolios and the
inconsistence oI the relationship across sub-periods, and Iinally indicated that the CAPM
may lack signiIicant empirical content.

Nevertheless, the main idea which leads to the less Iavourable evidence Ior the CAPM is
resulted Irom using beta as the only proxy Ior risk is questionable. There are other
variables identiIied to be signiIicant in explaining the cross-section return besides beta.
For example, the price-earning ratio eIIect, the size eIIect, the January eIIect, and the
book-market equity ratio eIIect.

A. P/E Ratio Effect
Price-earning ratio eIIect (P/E) was Iirstly reported by Basu (1977). He argued that there
is a relationship between investment perIormance oI a security and its P/E ratio. The P/E
ratio may be used as an indicator oI Iuture investment perIormance. In his research, he
Iound that during the period oI 1957-1971, returns on securities with low P/E ratio (high
E/P) tend to earn higher risk-adjusted rates oI return than suggested by their beta, and
vice versa. Basu (1983) Iurther analyzed the relationship between earning`s yield, Iirm
size and returns on securities oI NYSE Iirms. He conIirmed the signiIicant eIIect that P/E
ratio helps to explain the cross-section average returns in empirical tests, though; the P/E
eIIect is not entirely independent oI Iirm size and beta.

23
B. Size Effect
The size eIIect was Iirst introduced by Banz (1981), Iollowed by Basu (1983). The main
argument against the CAPM is that smaller equity capitalisation stocks on average have
had higher risk adjusted returns than larger Iirms. ThereIore, using beta as the single
proxy Ior measure risk is in doubt. The size eIIect has been thoroughly explored by
researchers, and has been Iound quite persistent in empirical tests since is has been
identiIied.

C. Seasonality Effect Especially the 1anuary Effect
In early research, RozeII and Kinney (1976) examined the seasonality in the trade-oII
between risk and return by using the Fama and MacBeth`s (1973) well known estimates
oI the two-parameter capital asset pricing model. They presented evidence on the
existence oI seasonality in monthly rates oI return on the NYSE Irom 1901-1974. With
the exception during the period 1929-1940, there were statistically signiIicant diIIerences
in mean returns among months that primarily due to large January returns. Dispersion
measures revealed no consistent seasonal patterns and the characteristic exponent seems
invariant among months. As a result, RozeII and Kinney (1976) concluded that the most
outstanding Ieature oI this seasonality is the higher mean oI return oI the January
distribution oI returns compared with most other months. Other seasonal peculiarities
include relatively high mean returns in July, November and December and low mean
returns in February and June.`

Tinic and West (1984) investigated the seasonality in the basic relationship between
24
return and risk during the period 1935-1982, and showed that the positive relationship
between return and risk in unique to January, and the risk premiums during the remaining
eleven months are not signiIicantly diIIerent Irom zero. In addition, Keim (1983)
continued the research and Iurther analysed the combined eIIects oI Iirm size and January
eIIect. He concluded that small Iirm returns during January are signiIicantly higher than
large Iirms return.

D. Book-Market Effect
The ratio oI book value to market equity has been Iound positively related to average
return. Firms with high B/M ratio tend to have higher average returns than predicted by
the CAPM. (E.g. Statman 1980 and Lanstein et al. 1985) The more recent studies by
Fama and French (1992, 1996, 2004) even suggested that the B/M ratio is more powerIul
than size in explaining the cross-section average returns.

Moreover, it has been conIirmed that there is a link among the Iirm size, P/E and B/M
ratio, as small size with low market price will induce to relatively low P/E and high B/M
ratio given the same level oI earnings and book value. According to Xu (2001), P/E and
B/M ratio are Iirm characteristics surrogating Ior distress Iactors, because small size, low
P/E and high B/M Iirms tend to have poor earnings prospects in general, and hence,
should be compensated Ior higher risk premium.

1he Fama and French Evidences
It is worth here to mention the series paper oI Fama and French (FF) as their works are
25
prominent Ior the arguments against the CAPM.

Fama and French (1992) careIully re-examined the beta-return relationship by using
cross-section regression approach oI almost 50 years US stock return data. FF Iirstly
allocated NYSE, AMEX and NASDAQ listed stocks on the base on their size, and then
sub-divided each size group into 10 beta-sort portIolios, in which get a total oI 100
portIolios. During the latest period 1963-1990, they observed a positive beta-average
return relationship and a negative size-return relationship in the Iirst pass sort; however,
aIter analysis oI the second pass sort, the beta-average return relationship becomes Ilat
while the size-return relationship still holds. AIter controlling the size, which allow the
variation in beta unrelated to size, the relationship between beta and average return
disappeared even when beta is the only explanatory variable. ThereIore, their tests did not
support the most basic prediction oI the SLB model, and FF was Iorced to conclude that
there is a very weak relationship between average return and market beta; beta has no
role in explaining the average return. On the contrary, book-market ratio was Iound to be
the most powerIul independent variable accounting Ior the cross-sectional variation in the
US stock markets. They also conIirmed that size, E/P and D/E ratios have some
explanatory power to explain expected stock returns other than market beta.

In addition, Fama and French (1996) got the same result by using the time-series
regression approach on the basis oI portIolios that contain stocks sorted on price ratios.
Ratios such as E/P, D/E and book-market ratios have been Iound involving inIormation
about expected returns missed by market betas. As a result, FF derived a three-Iactor
26
model, which suggested that combine the eIIects oI the excess return on a broad market
portIolio, the diIIerence between the return on portIolio oI small stocks and the return on
portIolio oI large stocks, and the diIIerence between the return on portIolio oI high B/M
stocks and the return on portIolio oI low B/M stocks provide a better indication oI
expected returns than the CAPM model.

Moreover, Fama and French (2004) Iurther emphasized that the CAPM has potentially
Iatal problems as other variables like size; price ratios and momentum have got
explanatory power oI average returns other than beta. They suggested that the CAPM is
not a useIul approximation Ior practical use as long as there are evidences that beta
cannot Iully explain expect returns.

To summarize above part, those unIavourable empirical results oI the CAPM in the US
markets aIter 1970s have generally yielded three implications: the intercept is higher than
the observed risk-Iree interest rate; the estimated risk premium is much lower than the
observed average rate oI return on the market portIolio in excess oI the risk-Iree interest
rate; and the explanatory power oI market beta Ior cross-section return is quite low.

2.2.2-3 Defence of the CAPM
There are many challenges proposed by the deIender oI the CAPM to argue the CAPM
anomalies that have been mentioned in the last section. However, according to Xu (2001)
the key point is although deviations may be economically important, there is little
theoretical motivation. Hence, those negative results Ior the CAPM may due to the use oI
27
data and methodology, and the market Irictions. This sub-section here will provide a
general description oI these contests.

Ex Ante and Ex Post Return
The SLB model implies relationship among expected (ex ante) returns which cannot be
observed, whereas only realised (ex post) returns can be observed Irom the market data.
ThereIore, empirical tests oI the CAPM have to be based on the actual returns instead oI
the expected returns, which should result in some degree oI deviations oI the empirical
results. MacKinlay (1995) suggested a partial solution to overcome this problem, which
is to examine the alternatives and make judgments Irom an ex ante point oI view.

Data Snooping
Data snooping reIers to a given set oI data that is used more than once Ior the purposes oI
inIerence or model selection. (Lo and MacKinlay, 1990) Statistical bias may be generated
by misuse oI data mining which can lead to suspicious results. Data snooping biases are a
particular concern in Iinance as data mining techniques are heavily used. Lo and
Mackinlay (1990) argued that the selection oI stocks to be included in a given portIolio
is almost never at random, but is oIten based on some oI the stocks` empirical
characteristics.` They have showed that data snooping can lead to rejections oI the null
hypothesis even when the null hypothesis is true. As a result, conducting classical
statistical tests on portIolios Iormed this way creates potentially signiIicant biases in the
test statistics.` However, it is quite diIIicult to quantiIy and make adjustment Ior data
snooping problems since there is little practical approach exists.
28
Investment Horizon
Kothari, Shanken and Sloan (1995) challenged the negative empirical results exposed by
Fama and French (1992). Instead oI the monthly interval to estimate beta, they measured
beta at the annual interval; and then regressing the average monthly return on the annual
beta. They have Iound that average returns do indeed reIlect signiIicant compensation Ior
beta risk, though beta alone accounts Ior all the cross-sectional variation in expected
returns is still in doubt. In addition, they cannot reject the explanatory power oI B/M ratio,
particularly the size eIIect. However, the explanatory power oI B/M ratio is not as strong
as suggested by Fama and French (1992) as they argued that past studies using
COMPUSTAT data are aIIected by selection bias and have provided indirect evidence.

Furthermore, MacKinlay (1995) provided a summary and possible explanation oI the
deIences against the negative empirical results Ior the CAPM model. He divided the
explanations into two categories: risk-based alternatives which include multiIactor asset
pricing models developed under the assumptions oI investor rationality and perIect
capital markets; and non risk-based alternatives which include biases introduced in the
empirical methodology, the existence oI market Irictions and problems arising Irom the
presence oI irrational investors, Ior instance, data snooping biases, computing returns
biases, transaction costs, liquidity eIIects and market ineIIiciencies. He conIirmed that
both categories can explain the violations oI the CAPM model; and Ior the category oI
risk-based alternatives, MacKinlay (1995) have Iound that the source oI deviations Irom
the CAPM is either missing risk Iactors or the misidentiIication oI the market portIolio as
suggested as in Roll (1977)`.
29
Conditional Beta-Return Relationship
The empirical tests oI the CAPM generally Iocused on the unconditional beta-return
relationship. The relationship between beta and return is hence analysed using a whole
sample period, which exclude the eIIect oI the macroeconomic environment. In general,
the overall results oI the unconditional tests are unsatisIactory.

An alternative explanation oI the weak, even Ilat relationship between beta and return
was proposed by Pettengill, Sundaram and Mathur (1995). Pettengill et al. (1995) argued
that the statistical methodology used to evaluate the relationship between beta and return
requires adjustment to take into account the diIIerences between realized returns and ex
ante returns. And they pointed out that the key distinction between the two types oI tests
was based on the precondition recognition Ior the SLB model, in which the model is
based on the expected returns not the realized returns. Thereby, the CAPM model does
not provide a direct indication oI the relationship between beta and return in the case oI
risk Iree rate excess realized market return. In addition, since beta measures the
sensitivity oI individual stocks to the market Iluctuation, high beta stocks tend to
outperIorm the market when the market booms and under perIorm the market when the
market is in recession. By contrast, the return oI low beta stocks during market recession
will be higher than high beta stocks as actually there is an inverse relationship between
return and beta during such periods. As a result, investors would expect to hold deIensive
stocks with low betas during market recession when there is a negative relationship
between return and beta.

30
Following their explanations, Pettengill et al. (1995) developed a conditional approach in
order to test the CAPM. In his approach, the beta-return relationship depends on whether
the excess market return on the market index is positive or negative. They argued that
when the excess market return is positive (up market), a positive relationship between
beta and return exists. On the other hand, there should be a negative return-beta
relationship in periods when the excess market return is negative (down market).
Consistent with their expectation, during the period 1936-1990, they observed a strong
support Ior beta as the positive beta-return relationship was Iound in up market months
when excess market return is positive, whereas a negative beta-return relationship was
Iound in down market months under the condition that excess market return is negative.

Fletcher (2000) examined the conditional beta-return relationship in international stock
returns in the period 1970-1998 by using the approach conditional beta-return relation.
AIter he split the sample into up market and down market months, the Ilat unconditional
relationship between beta and return Ior the whole period indeed changed. A signiIicant
positive relationship between beta and return in up market months and a signiIicant
negative beta-return relationship in down market months were observed. Hence, Fletcher
provided positive evidences Ior supporting the Pettengill et al. (1995)`s approach.

Moreover, the conditional approach oI Pettengill et al. (1995) does indeed provide some
inspiration Ior empirical testing oI the CAPM. Although both the above studies do not
exam the exclusive power oI beta in explaining the diIIerence between cross-sectional
returns, they gave an indication that some prior negative evidences against the CAPM
31
might due to the Iailure to consider the macroeconomic environment.

2.2.2-4 Evidences from Other Developed Markets
This part provides a general description oI the empirical test results Irom other developed
capital markets in order to examine the universality and applicability oI the CAPM. In
particular, the UK and Japan, which are the most important stock markets beside the US
in the world, will be discussed.

Heaston, Rouwenhorst and Wessels (1999) examined the ability oI beta to explain cross-
sectional variation in average returns Ior 2100 Iirms Irom 12 European countries during
the period 1978-1995 by using the value-weighted MSCI (Morgan Stanley Capital
International Index). In general, the relationship between beta and return is supported
when consider the European stock markets as a while, although the beta premium is
partly due to that high beta countries outperIorm low beta countries. However, the beta-
return relationship within countries show January eIIect as the premium Ior beta risk is
conIined to January months. Size is also Iound to be associated with average returns but
size premium is not conIined to the Iirst month oI the year. Moreover, they Iound
evidences that contrary to the US empirical results, beta is not cross-sectionally related to
size in the range oI international data.

Miller (2001) conIirmed that high-beta stocks typically Iail to earn excess returns
predicted by the CAPM model, but he suggested that this may arise because oI bias.
According to Xu (2001), Miller (2001) provided a comment on the problem oI January
32
eIIect as he suggested that this eIIect may result Irom tax-avoidance reasons associated
with investors` behaviour, which may be independent oI the CAPM model. Xu (2001)
Iurther argued that in the case that iI Miller`s point oI view is true, then the relationship
between beta and return Iorecasted by the CAPM is invalid in individual European
countries.

Elsas et al. (2003) compared the unconditional and the conditional test procedure oI the
CAPM by using Monte Carlo simulations and Iound that conditional test conIirms the
beta-return relationship. Then, they applied the conditional test to data Irom the German
stock market during the period 1960-1995. In contrast to previously studies analyzing the
German market, their empirical examination showed a statistically signiIicant relation
between beta and return. The Iailure oI previously studies to identiIy the beta-return
relationship may attributed to the Iact that average market risk premium have not been
signiIicantly diIIerent Irom zero in the sample period.

In addition, Iollowing Pettengill et al. (1995) approach, Tang and Shum (2003) examined
the conditional relationship between beta and return in 13 international stock markets Ior
the period 1991-2000. Despite the use oI two diIIerent proxies oI the world market
portIolio (MSCI world index or equally weighted world index), there is a signiIicant
positive relationship in up markets and a signiIicant negative relationship in down market.
Their Iindings are consistent with the studies oI conditional beta-return relationship in the
US. Tang and Shum indicated that beta is still an important and useIul tool to measure
risk Ior portIolio management and investments.
33

Further, in respect to the seasonality eIIect, evidences on the international markets were
Iound to support this statement other than the US. Gultekin et al. (1983) examined the
empirical evidence oI the stock market seasonality in major industrialized countries. The
strong seasonality in the stock market return distributions had been discovered in most oI
the capital markets around the world. In most countries, Ior example, the US,
disproportionately large January returns may be the underlying Iact to cause the
seasonality problem. Similarly, the reason behind such problem appeared to be caused by
large April returns in the UK markets. In addition, these January and April months are
also discovered to be coincided with the turn oI the tax year, except the case oI Australia.

Empirical Evidences from the UK Markets
Following Fama and French (1992) approach, Strong and Xu (1997) examined the cross-
section oI expected returns Ior the UK equities Ior the period 1973-1992. AIter testing the
relationship between expected returns and market value, B/M ratio, leverage, E/P ratio
and beta, they Iound that average returns signiIicantly positively related to beta, B/M
ratio and market leverage, whereas market value and book leverage are Iound be to
signiIicantly negatively related to average returns. However, they also observed that beta
becomes insigniIicant in multivariate regressions when size, or other accounting based
variables, Ior instance, leverage or B/M ratio is included. On the contrary to the US
empirical results, they Iound that B/M ratio and leverage variables are the only variables
that consistently signiIicant in explaining the cross-section oI UK expected stock returns,
whereas size eIIect is insigniIicant. Nevertheless, they suggested that the explanatory
34
power oI any combination oI accounting and market variables Ior average returns is low,
which indicate the low ability oI the examined variables prevailing in the US markets to
explain the cross-section average returns in the UK markets. In addition, their research
conIirmed the importance oI B/M ratio as Iound previously in the US markets.

According to Clare, Priestley and Thomas (1998), there is a linear and positive
relationship between beta and expected returns using monthly stock return data Irom the
UK markets during the period 1980-1993. In contrast to the US Iindings, their results
show a highly stable positive and signiIicant role Ior beta risk in the UK stock market.
Clare et al. (1998) Iurther suggested previously studies that have Iound B/M ratio play a
more signiIicant role in explaining the cross-section returns than beta may result Irom the
inappropriate implicit hypothesis in the regression process that the residual risk is
uncorrelated. They declaimed that the reports oI the death oI beta are premature.

Following the conditional approach oI Pettengill et al. (1995), Jonathan Fletcher (1997)
analysed the conditional beta-return relationship in the UK stock markets. Consistent
with Strong and Xu (1997), they Iound no evidence oI a signiIicant risk premium on beta
when the unconditional relationship between beta and return is considered. However,
aIter splitting the sample into up market and down market, a signiIicant positive
relationship between beta and return is observed when the market return exceeds the risk-
Iree return; and there is a signiIicant negative beta-return relationship when the risk-Iree
return excess the market return. The surprising Iinding oI his research is that the
relationship between beta and return is stronger in down market months than in up market
35
months. In addition, Fletcher (1997) also conIirmed the absence oI the size eIIect in the
UK stock returns as Clare et al (1998).

Moreover, as Toms et al. (2001) cited in Xu (2001), they tested the Fama and French
(1996) three-Iactor model oI the quoted equity securities on LSE (London Stock
Exchange) during the period 1975-1999, and suggested that the three-Iactor model
provide more superior empirical results than the CAPM as the intercepts are much closer
to zero than CAPM and R square is improved by the FF model.

Empirical Evidences from the 1apanese Markets
In general, the Japanese markets provide no supportive result Ior the CAPM model. Chan,
Hamao and Lakonishok (1991) related cross-sectional diIIerences in returns on a sample
set oI Japanese stocks Irom both sections oI the TSE (Tokyo Stock Exchange) to Iour
variables including: earnings yield, size, B/M ratio and cash Ilow yield. AIter applying
alternative statistical speciIications and various estimation methods to the data during the
period 1971-1988, a signiIicant relationship between the considered Iundamental
variables and expected return in the Japanese market were observed, with the most
signiIicant variables are B/M ratio and cash Ilow yield, which have the greater positive
impact on expected returns. Their empirical results automatically reject the validity oI the
CAPM in the Japanese market.

Nimal (2006) provided the latest studies oI the CAPM Irom Japanese markets. In his
research, the data Irom the TSE were divided into two periods, with the Iirst period Irom
36
July-1975 to December-1989 and the second period Irom January-1990 to December-
2002. He revealed that his empirical evidences on the CAPM model are similar to
previous studies, which are not supportive to the central prediction that there exists a
positive beta-return relationship. On the other hand, size and B/M ratio eIIects were
observed in the Iirst sample period, whereas their roles are not signiIicant in the second
sample period when the average market return is negative with a high volatility. However,
there was a support Ior the conditional relationship between beta and return, although
unlike the US Iindings, the beta-return relationship during down markets seemed to be
negatively steeper in the TSE than up markets. ThereIore, he concluded that because oI
the conditional relationship between beta and return, the use oI beta as a measure oI
market risk is still valuable.

2.2.2-5 Evidences from Emerging Markets
During the recent two decades, researchers have begun testing the validity oI the CAPM
in Emerging markets, especially the Asian stock markets. However, there are Iar less tests
oI the CAPM applied to emerging markets in comparison with the developed markets. In
Iact, the traditional CAPM may not be appropriate Ior emerging markets since it has been
designed on the basis oI developed markets. (Hwang and Satchell, 1999) The underlying
assumptions oI the CAPM indicate a perIect capital market, whereas emerging markets
are Iar less Irom standardized as the construction oI market institution is still in process.
ThereIore, it is not surprise to see that the major results oI the relationship between beta
and return predicted by the CAPM model is generally not supported in emerging markets.

37
Regarding to the emerging markets in Asia, Ior instance, China, Hong Kong, Taiwan,
Korea, Singapore and Malaysia are still under rapid development, although these stock
markets are relatively small compared to the major developed stock exchanges such as
NYSE and LSE etc. Wong and Tan (1991) tested the Singapore market during the period
1980-1985 by using weekly data. A negative relationship between beta and return Ior
both single stocks and portIolios were discovered. Bark (1991) examined the Korean
market and Iound a weak beta-return relation. Lee (1988) conducted a test oI the CAPM
by using the FM (1973) methodology. AIter analyzing the data Ior the period 1977-1987,
he showed that the tendency oI high-beta portIolios earns low returns, and vice versa,
which is inconsistent with the prediction oI the CAPM. Similar results were observed by
Cheung et al. (1993) as their empirical tests in both Korean and Taiwan markets Ior the
period 1980-1988 revealed weak relationship between beta and return. Huang (1997)
Iurther tested the Taiwan market during the period 1971-1993 by using daily returns. In
contrast to the prediction Irom the CAPM, the result indicated an inverse relationship
between returns and systematic risk, unique risk and total risk respectively. He also
claimed that the negative beta-return relationship should not be attributed to monthly
seasonalities.

Aydogan and Gursoy (2000) provided a comprehensive study Ior a data oI 19 emerging
markets as a whole. Despite the Ilat relationship between beta and return, their result
suggested that both P/E and B/M ratios have predictive power Ior Iuture returns,
particularly over longer time periods. In addition to Aydogan and Gursoy (2000)`s
Iinding, Drew and Veeraraghavan (2003) examined the assumption oI the multiIactor
38
asset pricing model proposed by Fama and French (1996) Ior emerging markets including
Hong Kong, Korea, Malaysia and Philippines. They suggested that Iirm size and book to
market equity could help to explain the explanatory variation in stock returns, whereas
beta alone was not suIIicient to describe the cross-section oI expected returns.

Nevertheless, the weak relationship between beta and return observed in emerging
markets may result Irom typical characteristic oI such markets rather than the
Iundamental Iatal problems oI the CAPM model. Beta is traditionally estimated based on
5-year historical data Iollowing the FM (1973)`s approach in developed markets, whereas
developing economies have experienced rapid change in which beta may be less stable.
Hence, like many studies suggested, time-varying risk exposure should be more
appropriate and suitable than constant risk exposure Ior emerging markets as emerging
markets are much more dynamic, especially Ior the paciIic-basin countries. Overall, more
complex models allowing time-varying risk exposure or additional risk Iactors may be
needed to explain emerging markets equity pricing. (Xu, 2001) However, such model is
diIIicult to derive in practice because oI the small and noisy emerging markets data.

The Hong Kong stock market should be particularly mentioned since Hong Kong is one
oI the international Iinancial and trading centres, and has been rated as the second largest
stock market in Asia and the seventh largest in the world. It is more likely to be regarded
as a developed market rather than an emerging market.

In general, researchers who have been Iocused on the direct ex-post test Ior the validity oI
39
the CAPM Iound that this is not applicable to the Hong Kong stock market. Mok et al
(1990) examined returns oI 37 Hong Kong Index and discovered the relationship between
beta and return was negative during the period 1980-1989. They claimed that the strong
negative correlation in the sub-period 1982-1983 led to the signiIicant negative
relationship. Moreover, an asymmetric stock market was also identiIied as the movement
oI stock prices in down markets were greater than their prices movement in up markets.

Cheugn and Wong (1992) Iurther analyzed the beta-return relation by using monthly data
oI 90 stocks Irom 1980 to 1989, and Iound a weak positive systematic relationship
between risk and return in most oI the period, except the discovery oI negative beta-
return relationship in period 1982 and 1983. They reached similar result by Iurther
splitting 90 securities into 18 portIolios, where a positive linear relationship between
systematic risk and return was revealed.

Moreover, in the paper oI Lam (2001), the relationship between beta and return was
studied by using the conditional method based on the conditional approach oI Pettengill
et al. (1995). AIter examining the data Irom the Hong Kong stock market during the
period 1980-1995, the empirical test results illustrated a strong conditional positive and
negative risk-return relationship. In addition, there was an asymmetric relationship to be
Iound Ior the estimated risk premium in both the markets and the down markets, as the
magnitude oI the down market premium was greater than that oI the up market.
Consequently, the estimated security market line (SML) in the down market was
negatively steeper than the positively sloped estimated SML in the up market under the
40
conditional CAPM approach. Nevertheless, he concluded that the conditional CAPM is
still practically useIul in the Hong Kong stock market despite the negative eIIects.

Conclusion
In this chapter, empirical tests results oI the CAPM are reviewed Irom both the developed
and emerging market. In particular, debates against the CAPM, deIence Ior the CAPM
and the conditional relationship between beta and return are discussed. All oI these aim to
provide some general ideas about the applicability oI the CAPM in practice.

Overall, the invalidity oI the CAPM is universal in both developed and emerging markets
including the three most important stock markets in the world: the US, UK and Japan, as
most studies have suggested some other variables are signiIicant in capturing the variance
oI average returns. However, the conditional approach is generally supported. In a word,
it seems that more complex models are needed in order to explain the risk-return
relationship in reality.








41
CHAPTER 3 THE CHINESE STOCK MARKET AND ITS
MARKET INSTITUTIONS

Introduction
Since the development oI the Capital Asset Pricing Model (CAPM), it has been widely
used in practical portIolio management and in academic research all around the world.
However, most empirical tests and discussions oI the CAPM have been conducted in the
US markets and other developed markets in Western Europe. On the other hand,
emerging markets especially the Asian markets have received considerably less attention.
Here, in this dissertation, CAPM will be empirically tested in the Shanghai stock market
oI China not only Ior the purposes to determine whether the CAPM is applicable in
Chinese markets, but also to help to achieve a good understanding oI the China equity
markets.

The main purpose oI this section is to provide background knowledge in respect to the
China stock markets. In this section, aIter a general description oI the Chinese stock
markets, its market institutions will be discussed, particularly the A and B shares, listing
procedure and market exit mechanism. Typical characteristics oI China equity markets,
which are quite diIIerent Irom developed markets, will considered thereaIter. Finally, a
concise summary oI Shanghai stock exchange will be drawn.

3.1 The Chinese Stock Markets
The Chinese economic reIorm and open door policies were put in Iorce in 1978 under the
42
leader oI Deng Xiaoping. In 1992, the Chinese government Iurther announced the
beginning oI the process to transIorm the economic system Irom a central planned
economy to a market economy. AIter maintaining the average oI more than 7 constant
growth rate oI GDP over 20 years, China has became one oI the most important emerging
countries. ThereIore, it is necessary Ior the establishment and development oI the Chinese
stock exchanges.

On 19
th
December 1990, the Shanghai Stock Exchange was set up in China, which
provided the indication to start the transIer to market economy, Iollowed by the
Ioundation oI the Shenzhen Stock Exchange on 3
rd
July 1991. Although China`s stock
markets have had relatively short histories, the above two stock exchanges have
expanded rapidly since their Iormal establishments with an annually average speed oI
25. In accordance with the historical data Irom China Finance Online, till the end oI
2005, the China stock market have already embraced 1476 listed stocks with 878 Irom
Shanghai Stock Exchange (SSE) and 598 Irom Shenzhen Stock Exchange (SZSE). Total
market capitalisation was over RMB 4.5 trillion, which was almost a quarter oI China`s
GDP (RMB 18.2321 trillion). Hence, it could be believed that China is becoming one oI
the most important emerging stock markets in Asia even in the world.

3.2 Market Institutions
This part consists oI two aspects: the A and B shares, listing procedure and market exit
mechanism.

43
3.1.1 A and B Shares
Both Shanghai and Shenzhen stock market have mainly two kinds oI stocks covering A-
shares and B-shares, in which A-shares are set Ior domestic investors trading with RMB
while B-shares are set Ior non-Chinese citizens or overseas Chinese investors dealing
with Ioreign currencies such as US Dollars or Hong Kong Dollars. For A-shares and B-
shares, the cited indices oI the Shanghai Stock Exchange (SSE) are the Shanghai A Share
Index and the Shanghai B Share Index respectively, and the cited indices oI the Shenzhen
Stock Exchange (SZSE) are the Shenzhen A Share Index and Shenzhen B Share Index.
All oI these indices are value-weighted.

In respect to B-shares, there was an abnormal phenomenon appeared especially prior to
2001 in the Chinese markets which was contrary to the Iinance literature. Since B-shares
are set Ior Ioreign investors with Ioreign ownership restrictions, their prices tend to
command higher than A-shares, which are open to domestic citizens. However, B-shares
were sold at signiIicant discounts relative to A-shares. A number oI reasons such as
illiquidity, traders who trade B-shares are ill-inIormed, or there is A-shares premium
rather than B-shares discounts were suggested by Ma (1996) and Chen et al. (2001). In
addition, Chan et al. (2002) Iurther emphasized that inIormation asymmetry is the
Iundamental Iactor that lead to the B-share discount puzzle, as domestic investors are
better inIormed than Ioreign investors.

Nevertheless, since 19
th
February 2001, limitations on China domestic citizens to deal B-
shares are liIted, and B-shares are open to both Ioreigners and domestic investors. Further,
44
according to the new regulation oI China Securities and Regulatory Commission (CSRC),
the Ioreign investors were licensed to invest in China`s A-share market Irom 2003, with
the purpose to make the Chinese stock markets more open and attractive to Iace the
international market competitions.

In addition, A-shares are Iurther divided into Iour subcategories: the state share, the legal-
person shares, the employee shares and the tradable A-shares. The state shares are those
owned by governments or solely-owned enterprises, while legal-person shares are held by
domestic legal entities and institutions such as securities companies or nonblank Iinancial
institutions. Since the Chinese stock markets are Iirstly designed to Iacilitate the state-
owned enterprises (SOE) reIorm, and mainly in the Iunction oI Iinancing the SOEs,
hence, the Chinese government intends to keep the state`s control status in the SOEs by
means oI the non-tradability oI the state and legal-person shares. Moreover, exclude the
employee shares that are oIIered at substantial discount to workers and managers oI a
listed company, tradable shares are very limited with only about 30 (2005) to total A-
shares.

1able 3.1: 1radable A-shares in both SSE and SZSE
Tradable Volume Issued Volume Tradable Value Market Value

100 Million Share
Proportion ()
100 Million RMB
Proportion ()
2001 1338.95 5154.83 25.97 13309.49 45606.01 29.18
2002 1511.02 5802.45 26.04 11925.08 41586.92 28.68
2003 1724.48 6361.56 27.11 12009.91 42764.81 28.08
2004 2005.24 7138.4 28.09 11889.44 42827.46 27.76
2005 2281.83 7664.71 29.77 8826.27 31379.22 28.13

45
Since there are only limited numbers oI tradable shares in Chinese stock markets, A-share
prices must be potentially pushed up and resulted in A-shares premium suggested by Ma
(1996) and Chen et al. (2001). In other words, the SSE and SZSE may represent the only
alternative investment to low-yield bank savings; hence, with a huge amount oI money
Ilowing around the limited number oI A-shares, supply cannot aIIord demand.

3.1.2 Listing Procedure and Market Exit Mechanism
In China, the securities market involves primary market and secondary market. The
primary market is to provide Iinance Ior the company through issuing stocks, which are
constituted by the stock issuers, securities agencies, and investors. The issued stocks can
trade openly in the secondary market aIter being authorized by the China Securities and
Regulatory Commission (CSRC). The secondary markets, Ior instance, Shanghai Stock
Exchange (SSE) is a place that oIIers investors to purchase and sell the issued stocks.
Thus, the secondary market is helpIul Ior the liquidity oI the securities and guarantees the
liquidity oI investors` assets, in which is based on the primary market.

Nevertheless, the number oI listed companies is still really small compared to thousands
upon thousands enterprises in China because the particular strict listing procedure
developed by the Chinese government. Prior to 2000, a system called quota system was
employed, in which the central government annually set the total amount oI capital that
could be raised by public oIIering oI companies in that particular year, and then allocated
the capital to each province and state department. Provincial governments hence
negotiated the quota Ior the region with the CSRC, elected Iirms that they would like to
46
support. As a result, a company that wants to be listed need the recommendation Irom the
municipal governments or state departments. Only those Iirms who have received
approval oI such quota will be allowed to apply Ior a public oIIering and listing.

Such system in China is quite diIIerent Irom the developed markets, Ior example, the US
where the approval oI an application Ior listing is at the discretion oI Exchange. It is
obviously that the process oI the quota system tightly controlled by administrative
authorities and highly lacking in transparency. Moreover, due to the reason that the China
stock markets were initially developed as a medium in order to assist the reIorm oI
ineIIicient state-owned companies, approved Iirms are mostly large state-owned
enterprises, especially in the SSE. However, the quota system changed since 2000 as
companies apply Ior listing oI their shares are subject to the approval oI the CSRC, and
only aIter gaining the approval oI the CSRC, Iirms can submit the applications Ior listing
to either the SSE or the SZSE. Though, recommendation Irom local governments would
make things a lot easier Ior applied companies.

On the contrary, despite the diIIicult process to get listed, once companies are listed, they
almost need not to worry about being delisted. In China, companies that have lost money
Ior two consecutive years would be placed on the Special Treatment` (ST) list, while
those that have lost money Ior three consecutive years are labelled as Partial TransIer`
(PT) and are supposed to be delisted iI the Iirm still cannot make proIit within 6-12
months. However, although the Securities Law implemented by the CSRC state that
companies which have lost money Ior three consecutive years should be delisted, in
47
actuality, very Iew oI the ST and PT stocks have been delisted. In comparison to the US
stock exchange where 3,600 companies being involuntarily delisted between 1995 and
2002, there were only 21 Iirms being delisted on the tow Chinese stock exchanges during
the period 1999-2004 (Min, 2005); Chinese stock markets are obviously not as market-
oriented as those in developed countries.

3.1.3 Typical Characteristics of Chinese Stock Markets
There are various other typical characteristics that distinguish the Chinese stock markets
Irom developed markets.

Firstly, individual investors rather than institutional investors in Chinese stock markets
are accounted as the dominant party in the 30 tradable securities, whereas in developed
markets, institution investors such as securities Iunds, commercial banks and insurance
companies are the major parties that contribute the trading value. Compared to
individuals, institution investors are supposed to be more rational in investing behaviour
because their ability and capability to collecting and analyzing inIormation. Nevertheless,
most institution investors in China are irrational with the objectives oI manipulating share
prices and get capital gains, which partly contributed the serious ineIIiciency oI Chinese
stock markets.

Moreover, investors in China tend to be risk-lovers instead oI risk-averse, and want to
make money in the short run. According to Li et al. (2001) only about 12 oI individual
investors hold their stocks Ior more than one year, whereas almost 37 oI them have
48
investment horizons less than three months. This results in a highly speculative Chinese
stock market.

Secondly, inIormation availability is poor in Chinese stock market. Although the State
Council requires listed companies to provide their CPA-audited annual reports to the
CSRC and related stock exchanges, and also to publish their annual reports in at least one
CSRC appointed newspapers and websites, inIormation transparency is still quite a
concern since many listed companies deliberately manipulate particularly their Iinancial
reports in collusion with the auditing party.

In addition to the concern about public inIormation disclosed by listed companies, the
Chinese stock market is regarded as a policy market` rather than an inIormation based
market. The state government intervene the stock markets by means oI policies in attempt
to create a Iair and orderly market. Leaving alone its eIIect on the market eIIiciency,
policies changes do indeed have a great impact on the share prices and investors`
expectation about stock returns. Policy is certainly the most important Iactor that
accounted Ior the market turbulence in China.

Thirdly, despite the Iundamental risks, investors in Chinese stock market Iace additional
risks, Ior example, market risk and policy risk. Regarding to the market risk, illiquidity is
the primary concern since investors have limited choices to diversiIy their investments,
especially when the market Ialls into a bear market. In respect to policy risk, one
important aspect is that policies rather than investment laws play a much more signiIicant
49
role in regulating the markets. Although China is in the process oI changing Irom a
planned economy into a market economy, many carry-overs Irom the planned economy
cannot be changed in a day. Other than market risk and policy risk that have been
identiIied above, risk oI listed Iirms is another point. Since listing in China is considered
as a quick way Ior Iirms to acquire capital Ior development, some companies make
Iictitious Iinancial statements to attract investors which result in artiIicial inIormation
suIIered Irom investors.

3.3 The Shanghai Stock Exchange (SSE)
With the sustaining and stable development oI Chinese economy, the SSE has expanded
dramatically since its Iormal establishment in December 1990. There are 878 listings at
the end oI 2005 compared to only 8 securities traded in the exchange at the very inception.
Listed Iirms include various industry distributions, such as commerce, real estate,
industry, public service and compositive companies. AIter IiIteen years oI operation, the
SSE has become the dominant stock exchange in the mainland China in terms oI the
number oI listed stocks and the total market value. SSE Index rose Irom the initial 100 in
December 1990 to 1161.05 in December 2005.

Furthermore, till the Dec 31, 2005, the SSE has embraced all kinds oI securities with a
total number oI 1069 listings, which includes 824 A-shares listed stocks, 54 B-shares
listed stocks, 25 Securities Investment Fund, 43 T-Bond Spots, 9 T-Bond Repurchase
Agreements, 47 Financial & Corporate Bond, and Iinally 18 Convertible Bond. (Table
1.2) The total market value that includes all securities has already achieved RMB 3.8
50
trillion.
1able 3.2 1he SSE 1rading Summary for the Year 25
Total A-Share B-Share
Securities
Investment
Fund
T-Bond
Spot
T-Bond
Repo
Financial
&
Corporate
Bond
Convertible
Bond
No. oI
Listings
1069 824 54 25 43 9 47 18
Issued
Volume
(Shares)
197004629 49195395 1035065 3980000 129480700 xxxxxxx 10065000 2557012
Market
Value
380678120 228560708 2400610 2609590 132874480 xxxxxxx 10936712 2734557
Tradable
Volume
(Shares)
161792099 14576988 1035065 3943950 129480700 xxxxxxx 10065000 1672837
Market
Value oI
Tradable
Volume
216675586 65145476 2400610 2585562 132874480 xxxxxxx 10936712 1800144
Source From: SSE Website. Updated: 2005-1231(URL: http://www.sse.com.cn/sseportal/webapp/datapresent/Trad
ingSummariesMonthlyAct?schYear2005&schMonth12&reportNameBizCompTradingSummariesMonthlyRpt&D
ATE2005-12&x16&y7)

However, despite the rapid expansion oI the Chinese stock market, it Iaces concerns
about the eIIiciency, the supervisory mechanism oI market, and the structure reIorm oI
listing Iirms. According to statistics Irom the SSE website, the SSE Index changed
51
dramatically over the IiIteen years. The SSE Index went down Irom 2245.42 on the 29
th

June 2001 to 1161.05 in December 2005 (Figure 3.1). It is obviously that SSE is an
immature emerging market, and there is an inconsistency between the perIormance oI
stock market and the continued growth oI Chinese economy.

Figure 3.1 Historical 1rend of the SSE Index

Source From: Yahoo Finance Online. Updated: 2006-0828 (URL: http://cn.Iinance.yahoo.com/q/bc?s000001.SS
&tmy&lon&zm&ql&c)

Figure 3.2 1he 1rend of the Movement of SSE Index
0
500
1000
1500
2000
2500
SSE Index
SSE Index 2245.42 1357.65 1343.59 1266.51 1161.05
2001 (June) 2002 (Dec) 2003 (Dec) 2004 (Dec) 2005 (Dec)


Conclusion
From the discussion above, it is obviously that the immature Chinese stock market
52
possesses its own typical characteristics as well as the common Ilaws in other emerging
markets, Ior instance, limited tradable shares with high market volatility and less market
oriented as a whole. Especially Ior the A-shares market, in which prices are more likely
to be driven by some qualitative non-Iundamental Iactors such as policies other than
market Iundamentals. Moreover, until now there are still a large amount oI untradable
state shares that make the CSRC Ieel headachy, though the original purpose Ior the
Ioundation oI Chinese stock market is to assist the reIorm oI ineIIicient state-owned
enterprises. Further, in particular, the China markets including the SSE have got highly
volatility, which should be bearing in mind in explaining the test statistics results in later
section.














53
CHAPTER 4 EMPIRICAL TEST OF THE CAPM

Introduction
This study is going to empirically test the CAPM in the Shanghai Stock Exchange (SSE),
which is one oI the two Chinese stock exchanges located in the city oI Shanghai. The
reasons Ior choosing Shanghai Stock Exchange as the research scope are as Iollows: (1)
Although both SSE and SZSE are national wide, and market institutions Ior them are the
same, the SSE is the largest and representative stock exchange in the Mainland China.
The empirical test oI CAPM in the SSE will be helpIul to provide a general indication Ior
the applicability oI the CAPM in Chinese stock markets. (2) There is strong possibility
that the two exchanges will merge in the Iuture, and the location would be in Shanghai
since the government tries to design Shanghai as the Iinancial centre in China besides
Hong Kong.

This chapter is organised as Iollows: section 4.1 introduces data and methodology used in
this study, Iollowed by section 4.2 that demonstrates and explains the test results, which
can be Iurther divided into 3 sub-sections: (a) 4.2.1 provides general Iindings oI this
study; (b) 4.2.2 discusses the results oI regression analysis, where the test results oI both
the unconditional beta-return relationship and the conditional relationship between beta
and return are examined; (c) 4.2.3 is Ior Security Market Line (SML) analysis, in which
the theoretical and empirical SML is estimated and compared under the conditional
CAPM.

54
4.1 Data and Methodology
It is necessary to choose the data scope and to make necessary calculation and analysis
beIore starting the empirical test. In this section, data collection and approaches regarding
to the study can be explained in detail.

4.1.1 Data Collection
The data used in this study include the closing prices oI randomly chosen stocks in the
last day oI each month and the Shanghai Stock Exchange (SSE) Index per month. The
SSE Index which is a weighted-average market capitalization index is used as the market
portIolio. Its initiated date was on the 19
th
December 1990 with the basic value oI 100,
and this index comprises all listed shares oI the SSE. In addition, all data that have been
mentioned above are taken Irom Stockstar Exchange SoItware and Yahoo Finance
respectively, the Iormer is downloadable Irom the Stockstar oIIicial website.

The period Irom January 2000 to December 2005 (6 years) was chosen as the basic data
scope to research the relationship between beta and return Irom January 2001 to
December 2005 (5 years/60 months) because the need oI year 2000 data to calculate the
return oI the year 2001. Although a 5-year period is not long enough to compare all
prices oI a chosen security to get precise result, it is still an enough period to represent the
real situation and trends in the stock markets since the history oI the SSE is not too long,
just over 15 years. Moreover, according to suggestions provided by Glen Arnold (1998),
commercially supplied beta calculations are normally based on at least 60 monthly
observations stretching back over Iive years.
55
The 60-month period in this study can be Iurther separated into two sub periods with the
Iirst sub-period Irom January 2001 to June 2003 which is 30 months, and the second sub-
period Irom July 2003 to December 2005 that is also 30 months. Previous research has
generally examined the beta-return relationship by using monthly return data, Ior instance,
Fama and MacBeth (1973), Black, Jensen and Scholes (1972), and Fama and French
(1992). As a result, monthly data is utilized here again as it more considers the seasonal
eIIect than using annual data, and also obviate the biased estimates oI systematic risk Ior
using weekly data.

In respect to individual security, there are 80 securities Irom A-class shares are chosen as
the security samples on a random basis Irom 5 diIIerent widely range, including industry,
commerce, real estate, public service and compositive enterprises. With the raw data,
monthly return Ior individual shares and the Shanghai Composite Index Irom January
2001 to December 2005 can be constructed. Moreover, all 80 sample shares will be
Iurther evenly grouped into 8 portIolios based on their individual beta (discussed later in
4.1.2 Methodology) in ascending order with each portIolio contains 10 securities.
ThereIore, the Iirst portIolio involves 10 stocks with the 10 lowest betas; on the other
hand, the last portIolio includes 10 stocks with the 10 largest betas. According to
Brigham (1985), most oI the studies actually analyzed portIolios rather than individual
securities as security beta is much more unstable than portIolio beta.

In addition, the bank saving deposit interest rate declared by the People`s Bank oI China
that is the Central Bank oI China is regarded as the proxy Ior the risk-Iree rate oI return,
56
since the deposit on saving accounts are guaranteed by the Chinese government.

4.1.2 Methodology
This empirical study examines the CAPM relationship between beta and return in the
SSE on the basis oI monthly returns Irom Jan 2001 to Dec 2005. The Capital Asset
Pricing Model (CAPM) was developed in the middle oI 1960s. It is the Iirst equilibrium
model Ior capital assets pricing, and also the Iirst capital assets pricing model that could
be tested using econometric method as Iollowing:

| ) ( | ) (
f m i f i
R R E R R E + = | (1)

Where:
) (
i
R E : The expected rate oI return on asset i Ior the period.
f
R : The rate oI return on risk-Iree asset.
) (
m
R E : The rate oI return on the market as a whole.
i
| : The beta value oI asset i, i.e. the sensitivity oI asset i to the market movements.

In this study, the empirical test is conducted in two aspects: a. the unconditional
relationship between beta and return; b. the conditional beta-return relationship during the
up market period and down market period.

Nevertheless, beIore the empirical test, the return oI a security and the market returns
have to be calculated Iirst in accordance with the Iollowing Iormula provided by Brealey,
57
Myers and Allen (2005):

100
) (
1
1

t
t t
t
P
P P
R (3)

Where:
t
R is the return oI a stock in the period t;
t
P and
1 t
P is the closing price level oI
share or index in the period t and t-1 respectively.

Thus, monthly return oI each security and the index are calculated based on equation (2),
and these returns will be used Ior (i) computing betas (ii) examining the relationship
between return and beta.

Moreover, as mentioned above, all 80 sample shares will be evenly sorted into 8
portIolios based on ranking their individual beta in ascending order, hence, calculating
and ranking beta is necessary. In general, the pre-ranking betas are estimated using 60
monthly returns. According to Arnold (2002), beta which indicates the sensitivity oI a
security to general market movements is:


2
,
) (
m
m i
i
R R Cov
o
| = (2)

Where: ) (
, m i
R R Cov is the covariance oI security i with the market portIolio, and
2
m
o is
the variance oI the market portIolio.

58
AIter calculating realized monthly return Ior each security, as well as Ior portIolio and
index, and also the beta oI each share and the portIolio in required diIIerent periods. The
next stage is to use the two-pass regression model that is Irom Fama and MacBeth (1973),
with modiIications suggested by Pettengill et al. (1995), to examine whether there is a
signiIicant positive risk premium on beta.

For the unconditional approach oI the beta-return relationship, Iollowing regression
model is used in order to test iI there is a positive risk-return relationship:


it i t t it
e R + + = |
1 0
(4)

The test oI the model is based on the mean oI the coeIIicients oI the monthly regressions.
The CAPM implies
ft t
R =
0
and ) (
1 ft mt t
R R = . Where
it
R is the return on asset i at
time t;
ft
R is the risk-Iree rate;
i
| represents the estimated beta oI asset i;
mt
R is the
market indexes return (market portIolio return) at time t; ) (
ft mt
R R is the market risk
premium; and Iinally
it
e is a random error term.

By using equation (4), the market risk premium can be estimated. II the risk premium, in
this case, the value Ior
t 1
is greater than zero (i.e.
ft mt
R R > ), hence, the predicted return
includes a positive risk premium that is proportionate to beta. On the other hand,
predicted return would contain a negative risk premium that is proportionate to beta iI the
risk premium is negative. Consequently, iI the realized return is more than the risk-Iree
59
return with a signiIicant t statistic, a positive unconditional relationship between beta and
return is supported. Such relationship provides important implications concerning about
the empirical test Ior a systematic relationship between beta and return.

Furthermore, the tested relationship between beta and return can be plotted on the
Security Market Line (SML), which shows return as a Iunction oI beta. However, it is
necessary to adjust the SML by some technique skills and statistical methodology, Ior
example, separate the SML during the diIIerent positive or negative market periods.

According to the Iormer experiences oI Pettengill et al. (1995) and Fletcher (1997, 2000),
there should be a positive beta-return relationship during the bullish market time interval,
whereas a negative relationship between beta and return should exist under the condition
that market is bearish. Pettengill, Sundaram and Mathur (1995) divided the monthly risk
premium estimates into two sub-sample periods that taking account oI whether the excess
market return is positive or negative. Jonathan Fletcher (1997, 2000) also divided the
sample period in his research into up market and down market periods based on the
criterion oI whether market return exceeded the risk-Iree return.

As a result, in order to test the conditional relationship, the total sample period in this
study should be divided into two types oI periods with the Iirst type is up periods when
market risk premium is positive, and the second type is down period when market risk
premium is negative. The separate analysis oI the two sub-sample periods can oIIer two
liner regression lines.
60

In respect to Figure 3.1 that has been presented in Chapter 3, the SSE Index had a
Iluctuated rising trend Irom 2000 to the middle oI 2001, achieving the top index oI
2245.42 on 29
th
June 2001, and then declined continuously with only 1161.05 in
December 2005. ThereIore, the market index in this study could be described as a very
short bullish market and a relatively long bearish market.

Similarly, in accordance with Pettengill et al. (1995) and Fletcher (1997, 2000), the
sample period oI this empirical study is split into two periods according to iI the market
return is positive or negative, and each period covers monthly closing prices oI each
security and the market indices as well.

Regarding to the positive and negative market return, Pettengill et al. (1995) adjusted the
Fama and MacBeth (1973) approach oI the unconditional beta-return relationship to
examine the conditional relationship between beta and return by arguing that studies
Iocusing on the beta-return relationship should take account oI the Iact that ex post rather
than ex ante returns are used in the empirical tests. It is obviously that investors would
expect greater return Irom high beta portIolio than low beta portIolio because oI the
compensation Ior additional risks. On the contrary, when the market return is lower than
the risk-Iree rate oI return, i.e. down market, investors would expect that the realized
return on a low beta portIolio would be greater than the return on a high beta portIolio
since high beta portIolio is more sensitive to the market and tend to loss more.
Consequently, the implication is that there should be a positive beta-return relationship
61
when excess market return is positive; and a negative beta-return relationship when the
excess market return is negative.

ThereIore, in the second stage, the cross-sectional regression should be estimated Ior the
conditional relationship between beta and return:


it i t i t ot it
e D D R + + + = | | ) 1 (
2 1
(5)

Where D is a dummy variable that equals to one iI the excess market return is positive
(i.e. D1 iI ) (
ft mt
R R ~0), and equals to zero iI the excess market return is negative (i.e.
D0 iI ) (
ft mt
R R 0);
t 1
and
t 2
is the monthly risk premium estimates in up market
months (positive excess market returns) and down market months (negative excess
market return) respectively. Equation (5) indicates that either
t 1
and
t 2
will be
estimated in a given month depending on the sign oI the excess market return.

The hypotheses predicated by Pettengill et al. (1995) are as Iollows:
H1:
1
is the average value oI the coeIIicient
t 1
which should be positive when it is
estimated in periods with positive excess market returns.
0 :
0 :
1
1 0
>
=

a
H
H


H2:
2
is the average value oI the coeIIicient
t 2
that should be negative when it is
estimated in period with negative excess market returns.
62
0 :
0 :
2
2 0
<
=

a
H
H


The above two hypothesis can be tested by using the standard t-statistic. Pettengill et al.
(1995) pointed out that two conditions are necessary Ior a positive tradeoII between risk
and return. II the conditional CAPM is valid, a systematic conditional relationship
between beta and realized return is supported in both cases, where the null hypothesis
should be rejected.

The last stage is to evaluate the regression and the Security Market Line (SML) based on
the results Irom the unconditional and conditional beta-return relationship analysis. SML
can be drawn on the basis oI the relationship between risk and return, where risk can be
measured by beta. Moreover, is should not been ignored that the calculation Iunction oI
Excel is used as a very important instruments through all processes.










63
4.2 Empirical Test Results and Discussions
Through literature review (Chapter 2), data collection and methodology presentation
(Section 4.1), it can be easier and clearer to test and analyze both the unconditional and
conditional relationship between beta and return.

4.2.1 General Findings
The sample period Ior this study extends Irom January 2001 to December 2005. The
monthly return oI stocks and the market index can be obtained Irom equation (2), with
the purpose to help to calculate the mean monthly return. Both the standard deviation and
beta oI securities are received on the basis oI equation (3) by using Excel. All above
results are shown in Appendix 1 that includes 80 shares chosen at random Irom A-class
shares in the SSE. The range oI mean monthly returns Ior these 80 securities are between
-37.90 (600120) and 11.50 (600002), the standard deviations are between 0.0899
(600052) and 0.5038 (600104), and the betas range are between -0.1523 (600132) and
2.5108 (600071).

In the scatter plot in Figure 4.1, Ior the total sample period Irom Jan 2001 to Dec 2005,
there is no obvious relationship between the risks estimated by standard deviation and
realized returns among 80 stocks. All observations have had negative returns except one
case (600002) that has the highest return without having the greatest value oI beta. The
correlation coeIIicient Ior the entire data sample is 0.4134. It can be seen though not
signiIicant Irom the plot data that lower risk stocks have had relative lower return
whereas high risk shares have got relatively higher return.
64
Figure 4.1
TotaI SampIe Periods
-0.5
-0.4
-0.3
-0.2
-0.1
0
0.1
0.2
0 0.1 0.2 0.3 0.4 0.5 0.6
Risk (STD)
R
e
t
u
r
n
Stock


On the other hand, there is no precisely linear relationship between betas and realized
returns among 80 securities either, as demonstrated in Figure 4.2 that is also a scatter
diagram. Nevertheless, the positive trend with the climbing betas does exist in the total
sample period, although it is not explicit. The correlation coeIIicient between beta and
return Ior the total sample period is 0.2693.

Figure 4.2
TotaI SampIe Periods
-0.5
-0.4
-0.3
-0.2
-0.1
0
0.1
0.2
-0.5 0 0.5 1 1.5 2 2.5 3
Beta
R
e
t
u
r
n
Stock


65
The total sample period is Irom Jan 2001 to Dec 2005, which is 60 months. These 60
months are Iurther divided into two sub-periods with the Iirst sub-period Irom Jan 2001
to Jun 2003, and the second sub-period Irom Jul 2003 to Dec 2005.

Figure 4.3 Figure 4.4


Figure 4.3 and Figure 4.4 represents the relationship between betas and realized returns
Ior all 80 shares in the Iirst and second sub-period respectively. There is an observation in
Figure 4.3 that has had the extreme high realized return but moderate value oI beta. In
contrast, a stock has got the highest return associated with the biggest beta as showed in
Figure 4.4. The correlation coeIIicients Ior the two sub-periods are 0.3094 and 0.3163. In
Iact, though there is still no linear beta-return relationship exactly, the positive
relationship between beta and return is somewhat obvious, especially despite outliers oI
some extreme observations.

Based on these betas estimated Irom the total sample period and two sub sample periods
respectively, 80 stocks are sorted into 8 portIolios and each portIolio involves 10 stocks.
Sub SampIe Periods 2001.1-2003.6
-0.4
-0.3
-0.2
-0.1
0
0.1
0.2
0.3
-1 -0.5 0 0.5 1 1.5 2 2.5 3 3.5
Beta
R
e
t
u
r
n
Stocks
8
Sub SampIe Periods 2003.7-2005.12
-0.6
-0.5
-0.4
-0.3
-0.2
-0.1
0
0.1
0.2
0.3
0.4
-2 -1 0 1 2 3 4 5
Beta
R
e
t
u
r
n
Stocks
66
PortIolio 1 contains shares with the lowest betas; hence, portIolio 8 includes stocks with
the highest betas. Furthermore, in the total sample period and two sub-periods, the
portIolio betas are estimated. Table 4.1 exhibits the mean monthly return, standard
deviation and beta oI the 8 portIolios in the whole sample period.

1able 4.1: Portfolios-1otal Sample Period
PortfoIio Return Std. Deviation Beta ()
1 -0.1654987 0.0886911 0.1074482
2 -0.2578897 0.0899062 0.4302563
3 -0.2235533 0.1042360 0.6006156
4 -0.1772967 0.1198148 0.7494762
5 -0.2000875 0.1581201 0.8938922
6 -0.1860875 0.1726019 1.0405933
7 -0.1741028 0.2139060 1.3143666
8 -0.1282828 0.2912941 1.8587302

Certainly, it could be seen Irom Table 4.1 that the risk (Std. deviation) basically climbs
up when the beta oI portIolios increases. Although there are some variations among
realized returns associate with rising betas, in general, the mean monthly returns Irom
portIolio 2 to portIolio 8 go up as well. However, one special case should be noticed here
is that portIolio 1 with the lowest beta but the second highest mean monthly return.

Figure 4.5
TotaI SampIe Periods
-0.3
-0.25
-0.2
-0.15
-0.1
-0.05
0
0 0.1 0.2 0.3 0.4
STD
R
e
t
u
r
n
Portf olios

67
Figure 4.
TotaI SampIe Periods
-0.3
-0.2
-0.1
0
Beta
R
e
t
u
r
n
Portfolios
Portfolios -0.165 -0.258 -0.224 -0.177 -0.2 -0.186 -0.174 -0.128
0.11 0.43 0.6 0.75 0.89 1.04 1.31 1.86


In addition, both Figure 4.5 and Figure 4.6 illustrate the average realized returns Ior 8
portIolios in combine with their standard deviation and beta respectively (with portIolio 1
consisting oI the lowest betas, as well as standard deviations) in the total sample period.
From Figure 4.5, it is clear that portIolio with higher standard deviation has had higher
rate oI realized return except portIolio 1. Meanwhile, Figure 4.6 illustrates that there is no
absolutely positive relationship between beta and realized return as the return oI
portIolios Iluctuating, but is has a climbing trend generally (despite portIolio 1).

Figure 4.7
Sub Period 1 (2001.1-2003.6)
-0.3
-0.2
-0.1
0
Beta
R
e
t
u
r
n
Portfolio
Portfolio -0.197 -0.182 -0.179 -0.199 -0.124 -0.098 -0.041 -0.133
0.05 0.35 0.55 0.7 0.84 1.1 1.33 2.02

68
In the two sub-periods, Figure 4.7 revealed that there is almost a clear positive trend
between beta and return Ior these 8 portIolios in the Iirst sub-period (2001.1-2003.6)
despite portIolio 8, as its return declines substantially. At the same time, the second sub-
period (Figure 4.8) has got similar situation compared with the total sample period, in
which portIolio 1 shows the third highest return with the lowest beta value. There is no
exact relationship between betas and realized return in the second sub-period (2003.7-
2005.12).

Figure 4.8
Sub Period 2 (2003.6-2005.12)
-0.4
-0.3
-0.2
-0.1
0
Beta
R
e
t
u
r
n
Portfolio
Portfolio -0.207 -0.293 -0.275 -0.236 -0.261 -0.203 -0.243 -0.134
-0.4 0.34 0.53 0.69 0.87 1.06 1.27 2.12


According to Brigham (1985), the standard deviation is oIten used by investors to
measure the risk oI a security or a portIolio. In Iinance, the basic concept is that the
standard deviation is a measure oI volatility; a volatile stock would have a higher
standard deviation when compared to a stable stock. Similarly, beta is commonly used to
measure the risk oI a security or a portIolio as well as standard deviation. Nevertheless,
beta is regarded as the tendency oI a security`s return in response to swings in the market.
It assesses the volatility, or systematic risk oI a stock or a portIolio in comparison to the
market as a whole.
69
In general, in respect to stocks in the Shanghai Stock Exchange, shares with higher risk
examined by standard deviation has got higher realized return than lower risk, and there
is also a positive but not explicit trend between systematic risk (beta) and return.
However, it is somewhat diIIicult to conclude that the clear positive beta-return
relationship Ior stocks exist in the SSE.

Moreover, as to portIolios, higher standard deviation, that is, higher risk has got relative
higher realized return generally, while similar situation applies to the relationship
between beta and return. But there are some extreme cases Ior all three sample periods,
Ior instance, portIolio 1 in the total sample period and sub-period 2, portIolio 8 in the Iirst
sub-period. Nevertheless, despite these extreme cases, there is a positive trend in most
time oI total sample period and the Iirst sub-period, in which higher betas are associated
with higher realized return.

4.2.2 Regression Analysis
Through the basic data collection and general Iindings, I run two regression models on
the basis oI Equation (4) and (5) to analyze the unconditional and conditional relationship
between beta and realized return respectively. The average monthly realized returns are
regressed on the betas, while the number oI observations in the cross-sectional
regressions is equal to the number oI stocks and portIolios respectively (80 stocks or 8
portIolios). The coeIIicients in the regressions are averaged, and hypothesis tests are on
the basis oI these averages. All regression results are illustrated in Appendix 2.

70
4.2.2.1 The Unconditional Relationship
The unconditional relationship between beta and return in Equation (4) is initially
examined over the whole sample period and then the two sub-periods. In respect to a
traditional test, it ignores the conditional nature oI the diIIerences between positive and
negative market risk premium. Pettengill et al. (1995) in his paper divided the whole
sample period (1936-1990) into three approximately equal sub-periods and tested
whether or not each oI three sub-periods have consistent results. Similar studies have
been Iound Irom both Jonathan Fletcher (1997) and Elsas et al. (2003) in which equal
sub-periods were used to test the beta-return relationship empirically. In this study, the
sub-periods are between Jan 2001 to Jun 2003, and Jul 2003 to Dec 2005 which include
30 months respectively. The coeIIicients estimated in the monthly cross-sectional
regressions (Equation 4) are averaged. Following the standard procedure, a t-test is then
used to determine whether the mean oI the coeIIicients is signiIicantly diIIerent Irom zero.
The results oI all 80 sample shares, both Ior the total sample period, and two sub-periods
with equal length, are shown in Table 4.2.

1able 4.2 Unconditional 1est Results--Stocks
Period
0

1
t-statistic P-vaIue
Total Period
(2001-2005)
-0.22482 0.040848 2.469934 0.015697
Sub-Period 1
(2001-2003.6)
-0.1908 0.051467 2.87352 0.005228
Sub-Period 2
(2003.7-2005)
-0.2742 0.05283 2.944585 0.00426
Note: A monthly cross-sectional regression is estimated by the mean month oI the index returns oI 80
shares and the estimated betas oI each share. The beta oI each security is estimated over the whole sample
period relative to the SSE index. The table includes the mean oI the monthly coeIIicients oI the intercept
(
0
) and slope (
1
). The t statistics are similar to the Fama and MacBeth (1973) t statistics and P-value is
Ior a t-test oI the null hypothesis in which the mean value oI the coeIIicient is 0. *SigniIicant at 1

71
The results in Table 4.2 demonstrates that there is a insigniIicant (t-test 2.4699)
relationship between beta and realized return in the Shanghai stock market Irom Jan 2001
to Dec 2005 at 1 level oI signiIicance, where the P-value is 0.015697 that is more than
1. The adjusted R square is 0.0725 (Appendix 2), which means only about 7.25 oI the
observed variability in total return can be explained by the independent variable beta. The
remaining 92.75 oI security`s total return variation is the non-systematic component.
On the contrary, diIIerent results showed over the two sub-periods as there is a relatively
signiIicant relationship between beta and realized return, where t-test is 2.87 and 2.94, P-
value is 0.005 and 0.004, and R square is 0.096 and 0.10 respectively. In addition, it is
obvious that the relationship between beta and realized return over the whole sample
period and two sub sample periods is positive (
1
).

The above Iinding is inconsistent with Fama and MacBeth (1973) in which a signiIicant
positive relationship between beta and monthly return were Iound in the US market. It is
possible to conclude that there is a positive but insigniIicant relationship between beta
and realized return over the whole sample period. However, a statistically positive
signiIicant beta-return relationship does observed in the two sub-periods. Consequently,
the null hypothesis ( 0
1
= ) oI strong signiIicant relation between beta and realized
return cannot be rejected Ior the total sample period, but can be rejected Ior the two sub-
periods.

Apart Irom the objects observed, in this case, the total 80 securities, the portIolio sorted
by beta oI each individual security is assessed as well. AIter dividing 80 shares into 8
72
portIolios with 10 shares in each portIolio in accordance with the ascending trend oI beta,
the Iirst portIolio hence has the lowest beta, and in turn, the last portIolio has the highest
beta. In the same way as did Ior total 80 stocks, the research period include the total
sample period and two sub sample periods. Table 4.3 illustrates the results oI the
regressions Ior portIolios.

1able 4.3 Unconditional 1est Results--Portfolios
Period P
0
P
1
t-statistic P-vaIue
Total Period
(2001-2005)
-0.22598 0.042177 1.775994 0.126074
Sub-Period 1
(2001-2003.6)
-0.19426 0.057545 2.026042 0.089151
Sub-Period 2
(2003.7-2005)
-0.26098 0.036466 1.563429 0.168983
Note: A monthly cross-sectional regression is estimated by the mean monthly returns oI portIolios and the
estimated betas oI each portIolio over 3 periods. The beta oI each portIolio is estimated over the whole
sample period and the two sub-periods relative to the SSE index. The table includes the mean oI the
monthly coeIIicients oI the intercept (P
0
) and slope (P
1
). The t statistics are similar to the Fama and
MacBeth (1973) t statistics and P-value is Ior a t-test oI the null hypothesis in which the mean value oI the
coeIIicient is 0. *SigniIicant at 1

Likewise, results in Table 4.3 shows that there is a weak insigniIicant relationship
between portIolio beta and realized return in the SSE in the period during Jan 2001 to
Dec 2005 at 1 level oI signiIicance as the t-test result is 1.7760 and corresponding P-
value is 1.26. The R square Irom Appendix 2 reaches 0.3446, which means 34.46 oI
observed variability in total rate oI return can be explained by portIolio beta. Unlike the
test Ior stocks that demonstrates a signiIicant beta-return relationship, diIIerent results
come Irom the two sub-periods. There is only a weak insigniIicant relationship between
portIolio beta and its realized return in both the Iirst and second sub-period. The t-tests
are 2.026 and 1.563, P-values are 0.089 and 0.169, and R squares are 40.62 and 28.95
73
correspondingly. Nevertheless, the slopes (P
1
) Ior the total sample period and two sub-
periods are all positive that indicates there is a positive relationship between portIolio
beta and realized return. As a result, only a positive but insigniIicant relationship between
portIolio beta and realized return Ior all the three sample periods has been identiIied.
Hence, the null hypothesis oI signiIicant relation between portIolio beta and realized
return cannot be rejected Ior the total sample period, either the Iirst sub-period or the
second sub-period.

In a word, there is a positive signiIicant relationship between stock beta and realized
return in the SSE over the two sub sample periods, whereas only a weak insigniIicant
beta-return relation exists in the total sample period. This is inconsistent with Fama and
MacBeth (1973), Richard and Dowen (1998), and Clare et al. (1998), where the empirical
examinations showed a positive signiIicant beta-return relationship in the US and UK
stock markets respectively. Regarding to portIolios, there is only a positive but weak
insigniIicant relationship between portIolio beta and realized return Ior all three sample
periods.

Although all sample shares and portIolios show a positive relationship between beta and
return (
1
~0, i.e. the risk premium is a little more than zero), the test oI the unconditional
relationship between beta and return cannot be supported because oI the identiIied
insigniIicant beta-return relationship. In addition, this result is consistent with most oI the
empirical tests implemented in other emerging markets. For example, the test oI Taiwan
stock market by Lee (1988), the test oI Korean market by Bark (1991), and the rigorous
74
test oI the CAPM Ior Hong Kong, Korea, Malaysia and the Philippines by Drew and
Veeraraghavan (2003). Evidences have been shown that beta alone is not quite adequate
Ior describing the cross-section oI stock returns, which is similar to my empirical Iindings.

4.2.2.2 The Conditional Relationship
The test Ior unconditional relationship oI the CAPM conducted in the Iormer sub-section
does not take into consideration oI the conditional nature that the relation between beta
and return is actually two sidesunder one situation where market risk premium is
positive and the other situation where there is negative market risk premium. ThereIore,
the beta-return relationship will be estimated by Equation (5) rather than Equation (4) in
the Iollowing part.

Market risk premium is deIined by the market return
mt
R and the risk-Iree rate oI
return
ft
R , that is, market risk premium equals to ) (
ft mt
R R . The market risk premium is
positive when ) (
ft mt
R R is more than zero, whereas negative market risk premium occurs
when ) (
ft mt
R R is less than zero. Through calculations by using Excel, there are 13
months in which the market risk premium is positive, while negative market risk
premium involves 47 degressive months in the total sample period. Similar to the
unconditional test, 8 portIolios are sorted by ascending beta oI 80 securities as
observations. However, portIolios in this conditional test contain diIIerent shares Irom
the portIolios in the unconditional test.

The result oI conditional relationship between portIolio beta and realized return are
75
shown in Table 4.4.
1able 4.4 Conditional 1est Results--Portfolios
Positive Market Risk Premium Negative Market Risk Premium
Period
1
t-statistic P-vaIue
2
t-statistic P-vaIue
Total Period
(2001-2005)
0.033512 2.576590 0.041961 -0.009644 -0.371917 0.722736
Sub-Period 1
(2001-2003.6)
0.146530 5.599902 0.001381 -0.016570 -0.663065 0.531921
Sub-Period 2
(2003.7-2005
0.068274 3.084228 0.021546 -0.017875 -0.662980 0.531972
Note: A conditional cross-sectional regression is estimated by the mean monthly returns oI portIolios and
the estimated betas oI each portIolio over 3 periods. The beta oI each portIolio is estimated over the whole
sample period and the two sub-periods in relative to the SSE index. The table includes the mean oI the
monthly risk premiums in up market months (positive excess market returns)
1
(the slope oI beta) and in
down market months (negative excess market returns)
2
(also the slope oI beta). The t statistics, which
are similar to the Fama and MacBeth (1973) t statistics, and P-value test whether the mean values oI
1
and
2
are signiIicantly positive and negative respectively. *SigniIicant at 1

Table 4.4 shows that the relation between beta and realized return is insigniIicant in
either up market or down market Ior the whole sample period at the signiIicance level oI
1, though up market has got relatively more signiIicance oI beta-return relationship
compared to down market. The t statistic is 2.577 in up market and the corresponding P-
value is 4.196, which is clearly higher than the signiIicant value. In the positive market
oI total sample period, although both t-stats and P-value indicates poor signiIicance oI
beta-return relation, the R square Irom Appendix 3 still reaches 0.5253, which implies
about 52.53 oI observed variation in mean rate oI return can be explained by the
portIolio beta. On the other hand, t-value and P-value Ior the down market is -0.3719 and
72.27 respectively. Particularly, the P-value is much higher than the 1 signiIicance
level. R square Ior the down market is only 0.0225 (Appendix 3) in the whole sample
period, that is, only 2.25 oI cross-sectional variation in average return can be explained
by the portIolio beta. Thus, it is obvious that the conditional relationship between realized
76
return and portIolio beta is not signiIicant in up market as well as in down market Ior the
total sample period. Furthermore, there is a positive (
1
= 0.0335) but insigniIicant
relationship between realized return and portIolio beta in positive market risk premium,
whereas a negative (
2
= -0.0096) insigniIicant relationship exists between realized return
and portIolio beta under the condition that market risk premium is negative. For the total
sample period, portIolios with higher beta tend to have higher rate oI return when market
premium is positive, while there is a negative trend between beta and return when the
market risk premium is negative, though this negative trend is relatively Ilat.

Hence, despite the positive and negative beta-return relation observed in up market and
down market respectively, the relationship between realized return and portIolio beta is
not signiIicant in both oI the two market conditions. The results oI the conditional test in
the Iull sample period can only be weakly supported Ior the conclusion that betas are
related to realized returns in the way predicted by the CAPM theory. Figure 4.9 below
illustrates the beta-return relation in up and down market correspondingly.

Figure 4.9
TotaI SampIe Period-Up Market & Down Market
-0.4
-0.3
-0.2
-0.1
0
0.1
0.2
Beta
R
e
t
u
r
n
Portfolio-Up Market -0.008 -0.103 -0.05 -0.059 0.0324 -0.006 -0.011 0.1309
Portfolio-Down Market -0.207 -0.204 -0.227 -0.268 -0.273 -0.251 -0.283 -0.197
0.07 0.48 0.74 0.84 0.91 1.06 1.27 1.86

77
Figure 4.9 conIirms the results. It shows the average realized return Ior the 8 beta-sorted
portIolios (with portIolio 1 that contains 10 lowest beta shares, thus portIolio 8 includes
10 largest beta shares) separately Ior total 60 months with positive and negative market
risk premium. Higher beta portIolios generally have got higher rate oI return than lower
beta portIolios under the positive market excess return condition. While under the
condition that market risk premium is negative, low beta portIolios tend to have higher
rate oI return compared to high beta portIolios. Nevertheless, such negative beta-return
relation under the negative market premium condition is relatively Ilat in comparison
with the relationship between portIolio beta and realized return in the up market.

In order to Iurther analyze the conditional relation, regressions are conducted among the
8 beta-sorted portIolios Ior the two sub sample periods. The results are also shown in
Table 4.4.

In the Iirst sub-period, there is a signiIicant relationship between portIolio beta and
realized return in up market whereas only an insigniIicant beta-return relation exists in
down market at the 1 signiIicance level. The Iormer has a t-test oI 5.6000 and 0.0014 oI
the corresponding P-value. R square reaches 0.8394 (Appendix 3), which indicates about
83.94 oI the observed variability in total return can be explained by the independent
variable beta, only 16.06 oI security`s total return variation is the non-systematic
component. In contrast, the latter has only got -0.6631 Ior the t-test with corresponding P-
value 53.19, the R square is only about 0.0683 (Appendix 3). Moreover, a positive
relationship between portIolio beta and realized return is observed in up market, while
78
there is a negative beta-return relation under the condition oI negative market risk
premium (
1
= 0.1465 and
2
= -0.0166 respectively). It is certain the test result oI up market
Ior the Iirst sub-period provide the strongest result so Iar.

On the contrary, there is an insigniIicant relationship between realized return and
portIolio beta either when the market risk premium is positive or the market risk premium
is negative (t-test 3.0842 and -0.6630, P-value 0.0215 and 0.5320, R square 0.6132
and 0.0683 respectively) Ior the second sub-period. However, similar to Iindings Ior the
total sample period and the Iirst sample period, up market has got a positive relationship
between realized return and portIolio beta, whereas a negative beta-return relation exists
in the down market.

To sum up, it is obvious that there is positive relationship between return and beta in up
market over the whole sample period and two sub-periods, while there is negative but
relatively Ilat beta-return relation in down market over the three diIIerent sample periods.
Nevertheless, the positive relation in up market is not signiIicant despite Ior the Iirst sub
sample period, and the negative relation in down market is extremely weak and
insigniIicant across all sample periods.

Consequently, in general, Ior the hypothesis oI H1 examined by Pettengill et al. (1995),
the null hypothesis oI no relationship between realized return and beta during the periods
oI positive excess market returns can be rejected in Iavor oI an expected positive
relationship at 1 level. Hence, the alternative hypothesis is true that there is a positive
79
relation in up market, though the positive relationship is relatively insigniIicant. On the
other hand, in the hypothesis oI H2, although there does exists a negative beta-return
relation, the negative relationship in down market is rejected as the null hypothesis
between realized return and portIolio beta cannot be reject across all sample periods
when the excess market return is negative, since the beta-return relation is extremely
weak and insigniIicant. As a result, the conditional relationship between beta and return
can not be supported.

4.2.3 Security Market Line (SML) Analysis
From Equation (1), it is clear that the CAPM states there should be a linear relationship
between a security`s or a portIolio`s return and beta. In theory, the relationship between
risk as measured by beta and the expected return is graphed by the security market line
(SML). According to the CAPM, all shares and portIolios lie on the security market line
with their positions determined by their beta exactly. However, as Arnold (2002)
indicated, in Iact, iI ten portIolios with diIIerent levels oI beta are created, the
relationship between beta and return is not exactly as described by the SML Ior these ten
portIolios. Although the plot points may not be precisely on the SML, it would be
reasonable to conclude that higher beta portIolios tends to earn higher rate oI return than
lower beta portIolios. Moreover, one extra point to note here is that iI a regression line
was Iitted to the observed data, its shape would be Ilatter than the SML passing through
the market portIolio plot points. Such results were approved by Brigham (1985) in the
early years.

80
In this part, the theoretical and empirical SML is estimated and compared under the
conditional CAPM Ior the total sample period Jan 2001 to Dec 2005. The conditional
linear regression tested by empirical evidence in the whole sample period was already
calculated in the sub-section 4.2.2 regression analysis. Here, the results oI empirical SML
can be represented by the Iollowing equations:

Up Market:
it i i
e R + + = | 03351 . 0 04581 . 0 (6)
Down Market:
it i i
e R + = | 00964 . 0 23015 . 0 (7)

The above equations show that there is a positive relationship between portIolio beta and
realized return when the market risk premium is positive, whereas a negative beta-return
relation exists under the condition that market risk premium is negative.

Figure 4.1 Figure 4.11
Up Market
- 0.2
- 0.1
0
0.1
0.2
0.3
0.4
0.5
0.6
-2 -1 0 1 2 3 4
Bet a
Portfolio
Down Market
-0.3
- 0.25
-0.2
-0.15
-0.1
- 0.05
0
0 0.5 1 1.5 2
Bet a
Portfolio


Figure 4.10 and Figure 4.11 below illustrates the relationship between realized return and
portIolio beta in up market and down market respectively Ior he total sample period. It
81
could be seen that all portIolios almost lie on a straight line empirically in both the up
market and the down market. This Iinding is consistent with the results revealed by
Richard Roll (1978), Brigham (1985), and Arnold (2002) etc. Furthermore, it is obvious
that portIolio with higher beta has got higher rate oI return compared to portIolio with
lower beta in the up market. Conversely, when under the condition that market risk
premium is negative, that is, down market, the portIolio with higher beta tends to have
lower rate oI return than lower beta portIolio.

However, in order to draw the theoretical SML, the original CAPM model (Equation 1)
has to be used to calculate the expected return. The saving deposit interest rate declared
by China Central Bank stands Ior the proxy oI the risk-Iree rate oI return
f
R . The
Shanghai Stock Exchange Index is regarded as the market rate oI return
m
R . Then the
linear regression estimated by the theoretical data can be calculated by using the Excel.

Consequently, there are two linear regressions to explain the relationship between
expected return and portIolio beta under the condition oI positive market risk premium
and negative market risk premium respectively. (Appendix 4)

Up Market:
it i i
e R + + = | 127719 . 0 000704 . 0 (8)
Down Market:
it i i
e R + = | 145598 . 0 000634 . 0 (9)

Similarly, Equation (8) and (9) demonstrates that there is a positive relationship between
expected return and portIolio beta when the market risk premium is positive. In contrast,
82
negative relationship between expected return and portIolio beta is observed when the
market risk premium is negative.

Figure 4.12
Up Market
-0.1
0
0.1
0.2
0.3
0 0.5 1 1.5 2 2.5
Beta
R
e
t
u
r
n
Theoretical SML Empirical SML

Figure 4.13
Down Market
-0.4
-0.3
-0.2
-0.1
0
0.1
0 0.5 1 1.5 2 2.5
Beta
R
e
t
u
r
n
Theoretical SML Empirical SML


Figure 4.12 and Figure 4.13 shows the contrast between the theoretical SML and
empirical SML in up market and down market respectively. It is clear that the slope oI
the empirical SML in either up market or down market is less than the slope oI the
theoretical SML, which implies a consistency with Brigham (1985) and Arnold (2002)`s
results as the slope oI the relationship between realized returns and systematic risk
deIined by beta is usually less than that oI the relationship between expected return and
83
beta predicted by the CAPM.

Moreover, it is clear that both the slopes oI empirical SML in up market and down
market is Ilatter than theoretical SML distinctly; especially under the condition that
market risk premium is negative, which indicates that investors in Chinese stock market
have got little conIidence. In respect to up market, both low and high beta portIolios tend
to have smaller rate oI return than theory suggests, whereas diIIerence is shown Ior the
down market where high beta portIolios has got higher rate oI return than the CAPM
predicts. The intercept value Ior SML in either up market or down market is negative,
thus realized rate oI return with beta equals to zero is lower than the risk-Iree rate oI
return; investors not only have not got reasonable compensations Ior taking risks in the
stock market but also to obtain a rate oI return that is lower than the risk-Iree deposit
interest rate declared by the central bank. Such abnormal phenomenon Iurther indicates
the lack oI conIidence Irom investors regarding to Chinese stock market, since the
compensations are too low Ior investors to eIIiciently make proIits or avoid losses in up
market and down market correspondingly. Investors would like to put money into the
bank rather than invest in the stock market.

Furthermore, the estimated SML during the up market (slope 0.0335) by realized return
and portIolio beta is steeper than that oI the estimated SML when market risk premium is
negative (Slope -0.0097). The volatility oI the portIolio beta in up market inIluences the
change oI the realized return more intensively than that in the down market. ThereIore,
the estimated risk premium Ior the up market and down market is asymmetric with the up
84
market risk premium greater than the down market.

Thus, according to above analysis, the empirical SML is not equal with the theoretical
SML. The conditional CAPM cannot be supported.

Conclusion
The empirical test results oI the CAPM by using Fama and MacBeth`s (1973) approach
with modiIications suggested by Pettengill et al. (1995) have been examined and
discussed in this chapter. Consistent with most Iindings in the emerging markets, the
beta-return relationship is Ilat in Chinese stock market, beta alone is not suIIicient to
describe the cross-section rate oI returns Ior stocks. Hence, neither unconditional nor
conditional CAPM can be supported.

Overall, although obviously there are limitations oI this empirical study such as the
deviation between the estimated risk-Iree rate and the real risk-Iree rate which may partly
lead to the unIavorable result, however, the inadequacy oI the CAPM may mainly be
attributed to market ineIIiciency as the Chinese stock market is certainly immature. For
instance, it has been long concerned that A-class shares in Chinese stock market have
little relation with Iundamentals Iactors, capital gains are more likely to be achieved by
non-Iundamental reasons such as Iads and market manipulation. Moreover, since the
typical characteristics oI Chinese stock market that the state owned capital and companies
occupy a large proportion, so that the central government can intervene in the stock
market directly. These excessive interventions Irom the government also results in the
85
many abnormalities oI the stock market.






















86
CHAPTER 5 SUMMARY AND CONCLUSION
To summarise, the main objective oI this paper is to test the validity oI the CAPM in
Chinese stock market by examining the unconditional and conditional relationship
between realized return and beta in Shanghai Stock Exchange during the period Irom Jan
2001 to Dec 2005, and compares the empirical SML with theoretical SML using the
conditional CAPM approach.

BeIore conducting the empirical test, I Iirst give a review in chapter 2 regarding to the
CAPM theoretical model and previous empirical Iindings Irom both developed markets
and emerging markets with the aim to provide some general ideas about the applicability
oI the CAPM in practice. Despite early evidences such as Fama and MacBeth (1973) that
seem to in support oI the CAPM model, evidences thereaIter give largely unIavourable
results as variables other than beta (e.g. size, E/P ratio etc.) are Iound be to signiIicant in
capturing the variance oI average returns.

In chapter 3, in order to provide background knowledge that would be helpIul to
understand the research base, market institutions oI the Chinese stock markets especially
the Shanghai stock exchange are described and discussed in detail. In general, other than
the common Ilaws such as high market volatility and less market oriented as a whole in
every emerging market, some other typical characteristics are identiIied regarding to the
Chinese stock markets. For instance, irrational investors instead oI institutional investors
are the dominant party. In particular, there are very limited tradable shares as most shares
that belong to the state owned enterprises are protected and restricted Irom trading by the
87
government, and share prices are more likely to be driven by some qualitative Iactors
such as policies rather than market Iundamentals. Hence, it seems that the CAPM
assumptions are largely violated in the Chinese stock market, and there is strong tendency
to believe that the CAPM will be invalid in the Chinese stock market.

Chapter 4 then empirically tested the CAPM by applying the approach Irom Fama and
MacBeth (1973), with modiIications suggested by Pettengill et al. In consideration oI
data availability and time constraint, the CAPM is limited in the Shanghai Stock
Exchange (SEE) Ior the period Jan 2001 Dec 2005 since the SSE is the largest and
representative stock exchange in the mainland China when compared to Shenzhen Stock
Exchange (SZSE).

Inconsistent with Fama and MacBeth (1973), there is a weak insigniIicant relationship
between stock beta and return over the whole sample period, whereas positive signiIicant
beta-return relation is Iound to exist only Ior the two sub-periods. Regarding to portIolios,
a positive but weak insigniIicant relationship between portIolio beta and realized return
Ior all three sample periods have been identiIied. Thus, the unconditional test Iailed to
support the validity oI the unconditional CAPM model in the SSE.

Moreover, Iollowing the conditional approach proposed by Pettengill et al. (1995), results
indicate that there is a positive relationship between portIolio beta and realized return in
up market over the whole sample period as well as two sub-periods, but only signiIicant
Ior the Iirst sub-period. However, when the market risk premium is negative, there only
88
exists an extremely weak negative and insigniIicant beta-return relation. Consequently,
inconsistent with the idea that there should be a signiIicant positive relationship between
beta and return in up market and a signiIicant negative relation in down market suggested
by Pettengill et al. (1995), the applicability oI the conditional CAPM is doubt in the SSE.

Further, the theoretical SML estimated by ex-ante expected returns compare to the
empirical SML estimated by ex-post realized returns are analyzed. Although results show
a consistency with Brigham (1985) and Arnold (2002) as the slope oI the relationship
between realized returns and systematic risk deIined by beta is less than that oI the
relationship between expected return and beta predicted by the CAPM, the intercepts Ior
the SML in both up and down market are less than zero, so that the realized return with
beta equal to zero is lower than the risk-Iree rate oI return. In addition, the estimated risk
premium Ior the up market and down market is asymmetric with the up market risk
premium statistically larger than that oI the down market, that is, the estimated SML is
steeper positively in the up market and Ilatter negatively in the down market.

As a result, I draw a conclusion that the CAPM is invalid in the Chinese stock market
since: (1) Overall, no signiIicant relationship between beta and return can be observed. In
the Fama-MacBeth regression, beta-return relation is positive but insigniIicant; Ior the
conditional CAPM approach, the relationship between beta and return is still
inconspicuous, though positive beta-return relationship are observed in up market
whereas negative relationship in down market. (2) Beta alone is not quite adequate Ior
describing the cross-section oI stock returns, as the explanatory ability oI R squares are
89
low in most oI the tests.

Nevertheless, there are major limitations that may inIluence the result oI this study.
Firstly, the sample may be too small, testing period may not be suIIicient compared to
studies that have been reviewed in Chapter 2. Secondly, the CAPM assumes a semi-
strong eIIicient market whereas the Chinese stock market is an obvious immature market,
Irom using such an immature market to implement the CAPM test empirically, great
deviations may be resulted. In addition, despite these limitations, Iinancial models may
not be applicable to every market since diIIerent markets have got diIIerent
characteristics, investor behaviour and political environment.

In conclusion, neither unconditional nor conditional CAPM can be supported or applied
eIIiciently in Chinese stock market. On the one hand, it is important Ior decision-makers
to bear in mind when making investment decisions that rather than solely rely on the
results oI the Iinancial models, diIIerent markets obviously have diIIerent characteristics
such as the Chinese stock market. On the other hand, the enormous economic
development in China over the past twenty years certainly produced the abnormal
Iinancial market subsequently. The Chinese government and the CSRC should emphasis
on improving the quality oI the listed Iirms, reIorm the market structure, and enhance the
ability to supervision, so that the Chinese stock market, especially the SSE could run to
the world level.


90
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97
APPENDIX 1: Data of 80 Listed Securities and Market Index


Average Return STD Beta ()
Index -0.0857306 0.14218
600001 -0.1225053 0.165338 0.819189
600002 0.1150044 0.43349 2.109887
600051 -0.2001906 0.224524 1.161518
600052 -0.2697894 0.089868 0.234299
600054 -0.064976 0.198222 0.100265
600055 -0.207481 0.217827 0.989723
600056 -0.2200162 0.253816 0.126581
600058 -0.1631152 0.280144 1.531694
600059 -0.1176502 0.201274 0.070316
600060 -0.1453038 0.161262 0.822352
600061 -0.2620495 0.322928 1.543396
600062 -0.045114 0.446575 1.799526
600063 -0.1817788 0.175348 0.890285
600064 -0.243508 0.099372 0.526345
600065 -0.2755321 0.26471 1.523908
600066 -0.1253568 0.166474 0.710594
600067 -0.1807627 0.245824 0.964469
600068 -0.1707816 0.154392 0.897912
600069 -0.1647041 0.189194 0.993553
600070 -0.2054272 0.242684 1.223579
600071 -0.1588251 0.442077 2.510768
600072 -0.1653189 0.211165 0.909145
600073 -0.135665 0.230733 0.045411
600074 -0.1974682 0.285206 1.565186
600075 -0.0820416 0.212133 0.706889
600076 -0.3132966 0.211751 1.19976
600077 -0.2662736 0.138067 0.523948
600078 -0.1722122 0.18936 0.3523
600079 -0.3001498 0.139707 0.399461
600080 -0.2575314 0.123079 0.682131
600081 -0.2485913 0.358632 1.458743
600082 -0.195291 0.283167 1.12971
600085 -0.0238068 0.143714 0.011888
600086 -0.201922 0.491222 2.305648
600087 -0.2479332 0.156649 0.094657
600088 -0.1615714 0.19595 0.785991
600089 -0.1411185 0.26866 0.785808
600091 -0.2258528 0.122062 0.766998
600092 -0.3096973 0.157667 0.698904
600093 -0.2301242 0.312245 1.00268
98
600094 -0.2548895 0.118543 0.391817
600095 -0.2608316 0.112069 0.607419
600096 -0.0253819 0.224996 1.189997
600097 -0.1674138 0.202442 0.512695
600098 -0.1524816 0.214585 1.004989
600099 -0.1625716 0.325127 1.823876
600100 -0.249703 0.192166 0.522613
600101 -0.1838691 0.20322 0.929028
600102 -0.1418042 0.310153 1.623069
600103 -0.2365285 0.149757 0.510227
600104 -0.0649626 0.503828 1.774251
600105 -0.2122563 0.134558 0.681679
600106 -0.1799095 0.125192 0.541485
600107 -0.2971204 0.117701 0.373626
600108 -0.2560447 0.185348 0.922211
600109 -0.1850002 0.218071 0.901783
600110 -0.1446337 0.366293 1.517573
600111 -0.1715894 0.197074 1.069939
600112 -0.1169609 0.216054 1.270366
600115 -0.0802257 0.237285 1.11454
600116 -0.1907271 0.204585 0.904875
600120 -0.3790036 0.174347 0.328225
600121 -0.3099105 0.160178 0.59192
600125 -0.1331032 0.17254 0.646039
600126 -0.1068201 0.227314 1.350948
600129 -0.1041932 0.478356 1.247274
600132 -0.0943236 0.237201 -0.15228
600148 -0.2949247 0.138085 0.220144
600157 -0.2556032 0.135829 0.38765
600166 -0.1876237 0.317804 0.636578
600172 -0.1859018 0.144737 0.323199
600180 -0.258649 0.187901 0.575758
600181 -0.3471129 0.222209 1.030599
600186 -0.2047745 0.2895 0.827763
600189 -0.1311023 0.187429 1.105731
600191 -0.2134098 0.114121 0.646834
600192 -0.2019877 0.133016 0.715907
600196 -0.2296556 0.227888 0.844208
600198 -0.2363312 0.194572 0.552099
600218 -0.2329242 0.192605 0.911712





99
APPENDIX 2: The Unconditional Regression Test Results


(a) Stocks (Total Sample Period)

Regression Statistics
Multiple R 0.269331
R Square 0.072539
Adjusted R Square 0.060648
Standard Error 0.077904
Observations 80

ANOVA
df SS MS F Significance F
Regression 1 0.037024 0.037024 6.100573 0.015697
Residual 78 0.473381 0.006069
Total 79 0.510405

Coefficients Standard Error t Stat P-value
ntercept -0.22482 0.016882 -13.3174 8.8E-22
X Variable 1 0.040848 0.016538 2.469934 0.015697



(b) Stocks (First Sub-Period 2001.1-2003.6)

Regression Statistics
Multiple R 0.309397
R Square 0.095727
Adjusted R Square 0.084134
Standard Error 0.101055
Observations 80

ANOVA
df SS MS F Significance F
Regression 1 0.084323 0.084323 8.257116 0.005228
Residual 78 0.796547 0.010212
Total 79 0.88087

Coefficients Standard Error t Stat P-value
ntercept -0.1908 0.019064 -10.0083 1.22E-15
X Variable 1 0.051467 0.017911 2.87352 0.005228



100



(c) Stocks (Second Sub-Period 2003.7-2005.12)

Regression Statistics
Multiple R 0.316292
R Square 0.100041
Adjusted R Square 0.088503
Standard Error 0.119723
Observations 80

ANOVA
df SS MS F Significance F
Regression 1 0.124281 0.124281 8.670582 0.00426
Residual 78 1.118025 0.014334
Total 79 1.242306

Coefficients Standard Error t Stat P-value
ntercept -0.2742 0.01973 -13.8979 8.36E-23
X Variable 1 0.05283 0.017941 2.944585 0.00426



(i) Portfolios (Total Sample Period)

Regression Statistics
Multiple R 0.586992
R Square 0.34456
Adjusted R Square 0.23532
Standard Error 0.034139
Observations 8

ANOVA
df SS MS F Significance F
Regression 1 0.003676 0.003676 3.154153 0.126074
Residual 6 0.006993 0.001165
Total 7 0.010669

Coefficients Standard Error t Stat P-value
ntercept -0.22598 0.024019 -9.40843 8.19E-05
X Variable 1 0.042177 0.023748 1.775994 0.126074



101



(ii) Portfolios (First Sub-Period 2001.1-2003.6)

Regression Statistics
Multiple R 0.637358
R Square 0.406225
Adjusted R Square 0.307263
Standard Error 0.04637
Observations 8

ANOVA
df SS MS F Significance F
Regression 1 0.008826 0.008826 4.104845 0.089151
Residual 6 0.012901 0.00215
Total 7 0.021728

Coefficients Standard Error t Stat P-value
ntercept -0.19426 0.029604 -6.56193 0.0006
X Variable 1 0.057545 0.028403 2.026042 0.089151



(iii) Portfolios (Second Sub-Period 2003.7-2005.12)

Regression Statistics
Multiple R 0.538017
R Square 0.289462
Adjusted R Square 0.171039
Standard Error 0.045517
Observations 8

ANOVA
df SS MS F Significance F
Regression 1 0.005064 0.005064 2.444309 0.168983
Residual 6 0.012431 0.002072
Total 7 0.017495

Coefficients Standard Error t Stat P-value
ntercept -0.26098 0.02478 -10.532 4.31E-05
X Variable 1 0.036466 0.023324 1.563429 0.168983



102
APPENDIX 3: The Conditional Regression Test Results

Up Market


(a) Portfolios (Total Sample Period)

Regression Statistics
Multiple R 0.724757
R Square 0.525272
Adjusted R Square 0.446151
Standard Error 0.052057
Observations 8

ANOVA
df SS MS F Significance F
Regression 1 0.017991 0.017991 6.638817 0.041961
Residual 6 0.01626 0.00271
Total 7 0.034251

Coefficients Standard Error t Stat P-value
ntercept -0.04581 0.023264 -1.96905 0.096477
X Variable 1 0.033512 0.013006 2.57659 0.041961



(b) Portfolios (First Sub-Period 2001.1-2003.6)

Regression Statistics
Multiple R 0.916185
R Square 0.839396
Adjusted R Square 0.812628
Standard Error 0.074627
Observations 8

ANOVA
df SS MS F Significance F
Regression 1 0.174645 0.174645 31.35891 0.001381
Residual 6 0.033415 0.005569
Total 7 0.208061

Coefficients Standard Error t Stat P-value
ntercept -0.07194 0.035635 -2.01891 0.090037
X Variable 1 0.14653 0.026167 5.599902 0.001381



103


(c) Portfolios (Second Sub-Period 2003.7-2005.12)

Regression Statistics
Multiple R 0.78308
R Square 0.613214
Adjusted R Square 0.54875
Standard Error 0.090222
Observations 8

ANOVA
df SS MS F Significance F
Regression 1 0.077432 0.077432 9.512462 0.021546
Residual 6 0.04884 0.00814
Total 7 0.126272

Coefficients Standard Error t Stat P-value
ntercept -0.13866 0.035251 -3.93362 0.007681
X Variable 1 0.068274 0.022136 3.084228 0.021546



Down Market


(d) Portfolios (Total Sample Period)

Regression Statistics
Multiple R 0.150114
R Square 0.022534
Adjusted R Square -0.14038
Standard Error 0.036603
Observations 8

ANOVA
df SS MS F Significance F
Regression 1 0.000185 0.000185 0.138322 0.722736
Residual 6 0.008039 0.00134
Total 7 0.008224

Coefficients Standard Error t Stat P-value
ntercept -0.23015 0.026802 -8.58701 0.000137
X Variable 1 -0.00964 0.02593 -0.37192 0.722736



104



(e) Portfolios (First Sub-Period 2001.1-2003.6)

Regression Statistics
Multiple R 0.261291
R Square 0.068273
Adjusted R Square -0.08701
Standard Error 0.039858
Observations 8

ANOVA
df SS MS F Significance F
Regression 1 0.000698 0.000698 0.439655 0.531921
Residual 6 0.009532 0.001589
Total 7 0.010231

Coefficients Standard Error t Stat P-value
ntercept -0.19285 0.027212 -7.08698 0.000396
X Variable 1 -0.01657 0.024991 -0.66306 0.531921



(f) Portfolios (Second Sub-Period 2003.7-2005.12)

Regression Statistics
Multiple R 0.26126
R Square 0.068257
Adjusted R Square -0.08703
Standard Error 0.049518
Observations 8

ANOVA
df SS MS F Significance F
Regression 1 0.001078 0.001078 0.439543 0.531972
Residual 6 0.014712 0.002452
Total 7 0.01579

Coefficients Standard Error t Stat P-value
ntercept -0.25319 0.028607 -8.85065 0.000116
X Variable 1 -0.01788 0.026962 -0.66298 0.531972




105
APPENDIX 4: The Theoretical Test Results for the Conditional
Relationship between Expected Return and Beta

Up Market

Regression Statistics
Multiple R 1
R Square 1
Adjusted R Square 1
Standard Error 1.15E-17
Observations 8

ANOVA
df SS MS F Significance F
Regression 1 0.261322 0.261322 1.99E+33 8.6E-99
Residual 6 7.88E-34 1.31E-34
Total 7 0.261322

Coefficients Standard Error t Stat P-value
ntercept 0.000704 5.12E-18 1.37E+14 1E-83
X Variable 1 0.127719 2.86E-18 4.46E+16 8.6E-99

Down Market

Regression Statistics
Multiple R 1
R Square 1
Adjusted R Square 1
Standard Error 4.43E-17
Observations 8

ANOVA
df SS MS F Significance F
Regression 1 0.042241 0.042241 2.15E+31 6.79E-93
Residual 6 1.18E-32 1.96E-33
Total 7 0.042241

Coefficients Standard Error t Stat P-value
ntercept 0.000634 3.25E-17 1.95E+13 1.22E-78
X Variable 1 -0.1456 3.14E-17 -4.6E+15 6.79E-93