Empirical Analysis of Noisy BM in China Stock Market

Abstract

Fama and French (2008a) argue that the limited success of the valuation formula using Fama and French 3 Factor Model is because the book−to−market ratio is a noisy measure of expected stock returns, which captures information about both expected cash flows and expected returns. To find a better Capital Asset Pricing Model for China stock market, this study takes the data in China from 1996 to 2010 to examine whether the origins of Book-to-Market ratio, BMt, in terms of past share issues, NSt−k,t, past changes in price and book equity, dMt−k,t and dBt−k,t, and the more distant changes in price and book equity summarized by BMt−k can be used to provide better estimates of expected returns than BMt alone. The hypothesis of this paper is that the components of BMt help disentangle the information in the ratio about expected cash flows and expected returns, thus enhancing estimates of expected returns. The empirical test in China stock market basically supports the hypothesis and over equity financing model well explains the differences and the anomalies in China stock market which includes that the net issue does not show the strong forecast power on the expected returns and the results differ for Microcap stocks (below the 20th China A−share stock market capitalization percentile) and All but Microcap stocks (above the 20th percentile of China A−share stock market capitalization percentile). In the meantime, motivated by Min Li and Li He (2009), to test the inefficiency of China stock market, the whole sample periods is spitted into three parts to compare the efficiency before and after the China Split−share Structure Reform (2005) which aims to enhance the efficiency of China stock Market. There are some evidences which, to some extent, show the inefficiency combined the Subprime Mortgage Crisis (2007) decrease the explanation power of the synthesized B/M ration to estimate the expected return.