| After more than 30 years of development,the A-share market is now the second largest stock market in market capitalization after the U.S.stock market.However,market participants are still mostly individual investors who prefer to speculative trading,the price discovery mechanism such as short selling of stocks is not yet perfect,and the effect on policy market is significant.These distinctive conditions are inconsistent with the basic assumptions of the rational expectations model.The classical rational expectations model includes three main assumptions: there is limits to arbitrage in the market,investors’ beliefs are rational,and they make decisions according to Expected Utility.From these assumptions,a risk-return tradeoff theory can be derived to explain the cross-section of expected stock returns:investors need an additional risk premium to hold stocks with high systematic risk.However,there are a large number of financial anomalies in the stock market that cannot be explained by the risk-return trade-off theory.In this article,after considering the conditions of the A-shares market,we use behavioral asset pricing theory to explain and predict the cross-section of expected stock returns.The behavioral asset pricing theory argues that investors’ irrational beliefs,irrational preferences,and limits to arbitrage in the market can affect the stochastic discount factor,which generates the failure of the risk-return compensation theory.We first examine how the stock characteristics related to irrational behaviors and limits to arbitrage affect the stochastic discount factor.Consistent with existing studies,we consider turnover,lottery returns,idiosyncratic volatility,and short-term reversal as proxies for heterogeneous beliefs（Han et al.,2021）,lottery preferences（Bali et al.,2011）,arbitrage risk（Stambaugh et al.,2015）,and noise trading（Chui et al.,2020）,respectively,and examine their return predictive relationships at the portfolio and individual stock levels.Our results show that all these characteristics predict significantly negative returns.Their decile high minus low portfolios earn-1.78%,-0.88%,-1.01%,and-1.09% per month,respectively.Moreover,the riskadjusted returns remain significantly negative.These results show that the riskreturn trade-off theory cannot explain the cross-sectional expected return in the Ashare market.The turnover and lottery return effects show that both irrational beliefs and irrational preferences impact the stock price,while the idiosyncratic volatility and short-term reversal effects indicate that the limits to arbitrage also affect the stock price.In addition,we also document that in the period of high（low）monetary policy uncertainty,the high minus low turnover,lottery return,idiosyncratic volatility,and short-term reversal portfolios have negative（positive）returns,which shows that investors are averse to ambiguous news.After the above empirical results show the significant irrational effect in the Ashares market,we introduce two behavioral biases,overconfidence and ambiguity aversion,to explain and predict the cross-sectional expected returns of the A-share market,respectively.In behavioral asset pricing theory,overconfidence and ambiguous aversion are among the most common irrational beliefs and irrational preferences assumptions,respectively（Chapman et al.,2021）.The psychological experimental evidence show that the two behavioral biases affect investors’ probability expectations about the distribution of future stock returns and thus the stochastic discount factor.Overconfidence means that investors have mistaken the probability of stock future return distribution and are convinced that their expectations are correct;ambiguity aversion means that investors do not know the true probability about future return distribution of stocks,and they make decisions based on the outcome with the lowest probability of occurrence.We rigorously theorize the intuitive explanations of Baker et al.（2011）and Daniel and Hirshleifer（2015）that overconfidence with short-selling constraints generates the Beta anomaly,and we introduce risk-averse preferences into Epstein and Schneider’s（2008）ambiguous information pricing model.We confirm the theoretical predictions of the overconfidence model and the ambiguity aversion model proposed in this paper through empirical analysis,respectively.The main conclusions are as follows:Beta anomalies of high（low）Beta low（high）Alpha and returns are significant in the A-share market.The high（low）Beta stocks are overpriced（underpriced）by overconfident investors.Because of short-selling constraints,rational investors cannot short the high beta stocks,which are the key reasons for the persistence of Beta anomalies in the A-share market.We attribute trading volume to overconfidence and show that the beta anomaly disappears after controlling the trading volume.This result is robust to different measures of trading volume or portfolio groupings.Controlling for several stock characteristics such as lottery returns,idiosyncratic volatility,and coskewness,the high minus low beta portfolios still earn significantly negative alphas.These results are different from those found based on the U.S.stock market.We construct two beta factors based on the Fama and French（1993）and Frazzini and Pedersen（2014）approaches.The two beta factors have positive Alpha under the benchmark risk-pricing models.When the turnover factor is added to the benchmark models,the beta factors earn insignificant alphas.Monetary policy uncertainty（MPU）will affect investors’ asset allocation decisions if they are ambiguity aversion.Using the news-based MPU index of Huang and Luk（2020）in China,we investigate the role of MPU on the crosssectional pricing of individual stocks.We find that the stocks with higher exposure to MPU have lower average returns,and the highest MPU beta decile generates an alpha of-1.08% per month compared to stocks with the lowest decile.The reward for bearing MPU is not simply risk compensation,nor is it explained by the wellknown firm characteristics.Further,the negative MPU effect is stronger in periods of bad MPU news than that in good news periods.To better understand the determinants of the negative MPU effect,we relate the MPU beta to other crosssectional predictors.Consistent with investor’ ambiguity aversion preferences,we document that the stocks with high MPU betas are often big,value,profitability,low illiquidity,and high coskewness stocks.Compared with existing researches,we have several innovations and contributions:（1）Because few asset pricing studies on the A-share market have discussed the impact on cross-sectional expected returns when deviating from the assumptions of the rational expectations model.Therefore,this paper first discusses the connection and difference between irrational beliefs,irrational preferences and limits to arbitrage,and the stochastic discount factor of the rational expectations model.Then,we examine whether a stochastic discount factor that only includes systematic risk（i.e.,risk-return trade-off theory）can correctly price irrational variables that reflect the three deviations.In addition,our selected stock sample and the sample period reduce the problem of potential selection bias due to incomplete sample coverage and short periods.For example,too short an estimation period may lead to test results that only reflect cross-sectional return changes in a specific period or an anomaly driven by a specific event,rather than the actual trend of cross-sectional return differences over time.Moreover,our sample stocks and sample periods reduce the problem of potential selection bias due to incomplete sample coverage and short periods.For example,too short the sample period may generate the results that only reflect cross-sectional return changes in a specific period or an anomaly driven by a particular event,rather than the actual trend of cross-sectional return differences over time.（2）Overconfidence and ambiguity aversion are irrational beliefs and irrational preferences that deviate from the assumptions of rational expectation,respectively.Both irrational behaviors affect investors’ probability estimates about the distribution of future stock returns and thus cause the stochastic discount factor of the rational model to fail to correctly price the cross-sectional expected returns of stocks.Combining some additional conditions,this paper establishes theoretical modeles to discuss how overconfidence and ambiguity aversion affect the crosssectional expected returns in the A-share market.The overconfidence model combined with the short-sale constraint can explain the beta anomaly;while the ambiguity aversion model based on ambiguous news predicts a negative and asymmetric cross-sectional expected return.（3）Our empirical results show that borrowing frictions（Black et al.,1972）,leverage constraints（Frazzini and Pedersen,2014）,lottery preferences（Bali et al.,2017b）,arbitrage asymmetries（Liu et al.,2018）,and skewness preferences proposed based on the U.S.stock market（Schneider et al.,2020）,fail to explain the Beta anomaly in the A-share market.Because of many individual investors and the shortsale constraints in A-share market,we propose a new overconfidence model to explain the Beta anomaly.The model provides a more general theoretical prediction for the possible forms of beta anomalies: overconfidence can generate positive or uncorrelated relation between beta and stock future returns,while the combination with short-sale constraints can even generate a negative relationship.Because previous theoretical and empirical studies have pointed out that the trading volume is positively correlated with overconfidence（Statman et al.,2006;Eyster et al.,2019）,we can easily test our theoretical prediction that the overconfidence drives the Beta anomaly in empirical studies.（4）Different from the assumption of Epstein and Schneider（2008）that investors are risk-neutral,we assume that investors are risk-averse.Our model predicts the negative ambiguous premium on the cross-section and asymmetric effects.Our MPU index is different from uncertain variables such as VIX and expert forecast standard deviation.We show that the ambiguous news related to A-share predicts negative cross-sectional returns.The market traders can earn excess returns based on this new factor. |
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