A Study On The Role Of Firm's Profit Instability In Asset Pricing And Investment Strategy In Chinese Stock Market

In the field of asset pricing study,which is the core in the modern financial theories,the researchers always try their best to explore the determinants of the asset price.Many scholars have began to pay more attention to the price information contained in the profitability of a firm.In particular,emerging literature have documented the profit premium,which implies the level of a firm's profitability is a significant determinant of future cross-sectional stock returns.However,in fact,there is another significant information contained in the profitability about the stock price could be explored in the future analysis.In the stock market,volatility of price is always an important indicator to capture the risk and uncertainty of a stock.Existing studies have found the evidence that the idiosyncratic volatility as well as the market volatility have predictive power for future stock returns.On the one hand,empirical results have found that there is significant relationship between the idiosyncratic volatility and future cross-sectional stock returns.One the other hand,researchers also find the market volatility plays an important role in predicting time-variation of the momentum effect.In fact,following the volatility of stock price,based on a firm's profitability,which contains fundamental information,we also could construct the instability of the firm's profitability to measure the risk and uncertainty related to the firm's operation.Therefore,inspired by the researches about volatility of stock price,we wonder whether the instability of firm's profitability could present similar patterns for future stock returns.Unfortunately,there is still little literatures provide insights into this issue.Based on the instability of firm's profitability,which contains economic information in firm's profitability,following the research paradigm in the field of empirical asset pricing,we systematically investigate the influence of the instability of firm's profitability on asset pricing as well as the investment strategy using the sample of A stock market in China.In this dissertation chapter 3 to chapter 5 are the core content including four aspects as below:In chapter 3,to understand the relationship between the instability of firm's profitability and future cross-sectional stock returns,we investigate the influence of the firm's profit instability on the cross-sectional stock returns using portfolio analysis and Fama-MacBeth regression.Based on the result,we further put forward profit instability effect.Also,we explore the long-term nature of the profit instability effect.In chapter 4,we further explore the source of the profit instability effect from the perspective of systematic risk compensation and mispricing.On the one hand,following the method provided by Daniel and Titman(1997),we construct a mimicking factor based on the profit instability effect in chapter 3,and try to explain the cross-sectional stock returns using risk loadings calculated by this mimicking factor.On the other hand,from perspective of mispricing,we analyze the influence of characteristics in Chinese stock market,which contain positive feedback trade,lottery preference and high arbitrage risk,on the profit instability effect.In chapter 5,we try to construct more efficient value strategy using the firm's profit instability which contains important information about stock price.Firstly,based on the book-market ratio,earnings-price ratio and sales-price ratio,we investigate the performance of traditional value strategy by single sort portfolio analysis.Then,combining with the profit instability effect in chapter 3,we try to improve the profitability of the value strategy by double ort portfolio analysis.In chapter 6,by constructing aggregate profit instability in a market level,we analyses the impact of the aggregate profit instability on time-variation of return based on momentum strategy in China's stock market.Furthermore,making full use of the predictable information about momentum effect contained in the aggregate profit instability,we construct a dynamic momentum strategy with dynamic weights.In summary,four conclusions are obtained in this paper.Firstly,there is significant profit instability effect in China's stock market,which indicates that firms with highly unstable profitability generate substantially lower future stock returns than those with low instability of profitability.In addition,this effect is still pronounced in a long-term period.Secondly,mispricing is primary reason for our profit instability effect.Specifically,positive feedback trading,lottery preference and high arbitrage risk,which are prominent in China's stock market,are responsible for existence of this effect.Thirdly,firm's profit instability,which could provide rich information to evaluate stock value,is helpful in improving profitability of the value strategy.Fourthly,the aggregate profit instability exhibits significantly negatively predictive power for the time-variation of return based on momentum strategy in China's stock market.If we construct a dynamic momentum strategy with dynamic weights by making full use of the predictable information about the return of momentum strategy contained in the aggregate profit instability,this dynamic strategy would exhibit stronger profitability than the traditional momentum strategy.Overall,there are four points of innovations could be summarized as below:Firstly,based on firm's fundamental information,this paper reveal the negative relationship between the instability of firm's profitability and future cross-sectional stock returns.In previous studies,based on firm's profitability,which is an important aspect of measuring company's market competitiveness,researchers usually pay more attention to the influence of level of firm's profitability on cross-sectional stock returns.However,although instability of firm's profitability also contains important economic information about the firm's operation,scholars just pay little attention on this instability in research of asset pricing.At present,there are few literatures systematically discussing the impact of profit instability on cross-sectional stock returns,and even less about China.So,this paper,which exploits more detailed information contained in firm's profitability,is an important investigation to fill up the gap about this issue,and contributes to the development of empirical asset pricing.Secondly,to understand the source of profit instability effect,this paper propose that positive feedback trading,lottery preference and high arbitrage risk,which are prominent in China's stock market,are responsible for existence of this effect.Because China's stock market was established relatively late,compared with stock markets of developed countries,there is a big gap in the maturity of investors and the perfection of trading rules,which indicates the irrational factors such as positive feedback trading,lottery preference and arbitrage risk are more obvious in the actual market.Therefore,from the perspective of mispricing,this paper innovatively uses the above characteristics of China's stock market to analyze the theoretical mechanism behind the profit instability effect.Thirdly,combining with price information contained in firm's profit instability effect,we establish a more efficient value strategy.In this paper,we have documented that stock price of firm with high profit instability is overpriced because of irrational factors in stock market.In factor,above result provide another standard to evaluate a stock value.Therefore,considering the value information provided by firm's profit instability,this paper innovatively construct a new value strategy,which could significantly improve the profitability and applicability of value strategy in Chinese stock market.Fourthly,this paper reveals the predictive power of aggregate profit instability,and constructs a new dynamic momentum strategy with dynamic weights in China's stock market.It has been found that the traditional momentum strategy,which has good performance in developed countries,is not an effective investment strategy in China's stock market.So,to improve the performance of momentum strategy in China's stock market,this paper innovatively construct a dynamic momentum strategy with dynamic weights by making full use of the predictable information about momentum effect contained in the aggregate profit instability.Compared with traditional momentum strategy,our dynamic momentum strategy has better performance in actual market,which indicates great economic value.At the same time,our analysis also innovatively links the risk of aggregate profit instability with the momentum effect,and provides an alternative explanation for the source of the momentum effect of Chinese stock market from the perspective of risk compensation.