Essays on Mispricing in the Chinese Stock Market

Along with Chinese economic development, the Chinese stock market is growing rapidly, and is now the second largest stock market in the world. However, despite its size, the Chinese stock market trades like the wildest emerging markets, with huge volatility, big boom and bust cycles, driven by fast-trading individual investors, and heavy involvement from the government. Owing to the peculiarity of the Chinese economic and political system, there are some unique structures within the Chinese stock market. In one sense, this makes the Chinese stock market an interesting laboratory. This dissertation comprises three single-authored essays. The first two analyze a special phenomenon, called B-share discounts in the Chinese stock market, seeking to explain why this phenomenon exists from the perspective of exchange risk. It shows that dual-class stock price disparity in the Chinese stock market can be explained, in a way, by exchange risk, meaning that “to some extent, investors are rational and ask for compensation for taking extra risks”. This is in line with the classical efficient market theory. The second essay uses this phenomenon as a natural experiment to test whether a new reform policy, namely granting permission for short selling, benefits the efficiency of the Chinese stock market. When the Chinese government lift the ban on short selling in the Chinese stock market, mispricing decreases significantly, even though the volume of short selling in the Chinese stock market is trivial relative to total trading volume. Instead of studying a particular set of stocks, the third essay focuses on the mispricing formation mechanism at the general market level. The market results show that both the resale option and inflation illusion hypotheses can explain the level of market mispricing. Only investors’ heterogeneous beliefs affect the volatility of market mispricing, in line with the resale option hypothesis prediction. Additionally, the results show that state-controlled industries tend to be underestimated more, when mispricing is negative, but to be overvalued less, when mispricing is positive