Are Firm Size and Book-to-Market Priced Risk Factors? Chinese Evidence

Abstract

This study investigates the robustness of the Fama and French three-factor model in the context of the Shanghai and Shenzhen stock exchanges spanning the period 1995–2008. We show that the three-factor model does a meaningful job in describing the cross-section of stock returns in this developing market. However, whereas the stocks of small firms attract higher market risk (outperforming on average, but underperforming when the market declines), high book-to-market (B/M) stocks outperform in both rising and falling markets. Neither are we able to provide a risk-return based explanation for B/M stocks in terms of either higher leverage or volatility (the correlations being in the opposite direction). Overall, our findings are that B/M captures “value-for-money” firms (proxied by high earnings-to-price and cash-flow-to-price ratios) that are associated with lower levels of debt, and hence lower volatility.

Keywords: Chinese stock market, Fama and French model, Up-market, Down-market, Volatility

JEL Classification: G11, G12, G15