CAPM in China

CAPM
CAN IT STAND THE TEST OF TIME IN CHINA?
CAPM in China

INTRODUCTION

This review is intended to shine light upon the model used for asset pricing in the
Chinese financial markets and real estate markets as the Chinese market is the second largest
market in the world with the largest population as of 2019. CAPM (Capital Asset Pricing Model)
as defined in finance, is a model used to determine and analyze a theoretically appropriate
required rate of returns to an asset. The history of CAPM began in 1964 developed by William.F.
Sharpe, Jack Treynor, John Lintner and Jan Mossin working on the Harry Markowitz modern
portfolio theory. For their services, Miller, Sharpe, and Markowitz received the Nobel Memorial
Prize in 1990 for their contribution to the world of Financial Economics. The model has stood
against the test of time, although in recent years the model has been under immense pressure due
to its underlying assumptions (Jianhua Dai, Jian Hu & Songmin Lan, 2014).

 Investors hold diverse portfolios. (Unsystematic risk has been diversified hence ignored)
 Single period transaction horizon. (returns of six months can’t be compared to one-year
return)
 Investors borrow and lend at risk-free rates.
 Perfect capital market.

The empirical viability of CAPM in the Chinese markets is observed and analyzed in this
paper, does CAPM work in China? This question takes into account various markets that exist in
the Chinese ecosystem, namely the real estate and the financial sector which consists of the
Chinese stock market. The articles chosen for this are hence based on their validity of being able
to perform in the stock market and real estate market of China. All of the papers are validated by
using the AI index of eigenfactor. The differences in the classification of “success” are
understood as it varies from paper to paper hence, by certain definitions CAPM can be defined as
either a functional model or a dysfunctional model.

LITERATURE REVIEW
Many studies question the effectiveness of CAPM in any market, let alone China with its
inherent market flaws. These flaws consist of but are not limited to, the reliability of data
collected from a policy-driven market and large government regulations coupled with an
interesting mix of investors from various backgrounds. Apart from these factors, it should also be
considered that there is a non-tradable share of the market which is wholly state-owned. In
China, two kinds of shares exist: A shares and B shares, these two kinds of shares have equal
voting power, while the “A-share” is much more important for domestic markets and vice versa
for the “B-share”. The primary purpose of the ‘B-market” was to attract foreign investors.
There are issues in regards to macro-environment in Chinese real-estate
markets. Chinese statistics are often stigmatized for lacking relevance and transparency, such as
the CPIs not being public information. Political interference has always been an issue in the
recording and publication of statistics. So, when interpreting the use of these statistics in the
analysis and calculations, one must always be mindful of the economic indicators and political
agenda. One such difference in statistics is that the Chinese government measures GDP with the
CAPM in China

production approach, while the USA uses the expenditure approach. The Chinese approach of
capturing value is more one-sided and can have quite a large impact on the office property
markets as a whole, as well as the recording of the data of these property markets.

CAPM IN CHINESE STOCK MARKET

The standard CAPM considers only mean and variance when pricing risky assets.
Therefore, pricing bias by CAPM is inevitable. Risk-adjusted three-moment CAPM is proposed
by introducing a liquidity factor in the traditional three-moment model. The model is then tested
empirically by using the Chinese A-share market data (Chen, Li, & Wang, 2011). It is observed
when the market liquidity is poor, then the liquidity of an individual asset will also be poor. This,
in turn, results in a higher required rate of return. This results in the investors demanding a
premium for illiquidity cost and investors may be willing to pay a premium for more liquid
stocks in the Chinese Stock Market (SSE). Evaluation of CAPM gives way to two kinds of risks
namely “unsystematic risk” and “systematic risk”. Unsystematic risk is that which is associated
with specific industries in general or a specific company. It is inherent to the nature of the
specific industry or field in which a company exists. Whereas systematic risk is that which is
associated with the entire market as a whole. Every firm and company in a market is subject to
systematic risk. This is a kind of risk that cannot be eliminated through diversification, as with
unsystematic risk. It exists intrinsically in the stock market, and all assets price models are
subject to it if they are to operate in that market.
CAPM has been evaluated in Chinese markets for almost 30 years now since the
inception of the Chinese stock market in 1990 by the government to reform a centrally planned
economy into a more flexible market economy. These reviews often have mixed results. Sun and
Tong (2000) did find some empirical support for traditional CAPM in the Chinese markets. The
regression results observed by (Dai, Hu, & Lan, 2014) state that there is a linear relationship
between the asset portfolios and the excess returns on assets in the Shanghai market. As well as
that for the portfolio constructed, the CAPM model is definitely already established in the
Chinese stock market. And lastly that the R squared of the portfolios was significantly higher
than that of the front board R squared data (Jianhua Dai, Jian Hu, & Songmin Lan, 2014).
However, tests on the Shanghai stock market alone is not enough to describe the average stock
returns in Chinese markets some test such as those by Mao even found that the relationship
between return and Beta is linearly negative (Gao Yan, & Yang Xin, 2018). Yang argues that the
relationship established by CAPM in Shanghai is not what was expected from the model. The
risk is not the only factor that determines the returns on stock. Other factors include the size of
the firm; ratio of negotiable share to total share; return on equity; and the total turnover on
trading (Gao Yan, & Yang Xin, 2018).

CAPM IN CHINESE REAL ESTATE

CAPM as a financial model has been used frequently in the stock market, however, this
model is also applicable for basing relationships of returns and returns in property investment.
The CAPM is used to model the Chinese property returns by Lecomte (Lecomte, 2013). It is
stated specifically that the model used is based on a risk structure and that this risk structure is
categorized in terms of systematic and idiosyncratic risk. The Chinese cities covered under this
CAPM in China

are Shanghai, Guangzhou, Shenzhen, and Hong Kong. The data observed has been conducted at
a scaled-down level, since the data at the national level has only been observed since 2007 which
deems the results from the holistic view of the Chinese real estate market to be futile due to lack
of observable data. The cities used in the tests have risks that are all overwhelmingly
idiosyncratic. Idiosyncratic risk is also referred to as systematic risk, this risk is present only in a
particular asset and not the whole investment portfolio. The risk is present in all the cities but is
especially prominent in Shanghai and Guangzhou. It is almost twice as high in Guangzhou as it
is in Beijing. So, Shanghai’s office market is the most attractive in terms of the risk to return
ratio. This lines up with the findings of Tse, Chiang, and Raftery (1999). However, as a thinking
point, it is important to note that the paper of Tse, Chiang, and Raftery (1999) looks at total
returns, whereas the paper of Lecomte (2013) looks at capital returns.
The real estate has produced returns equal to common stock but with less variance. The
real estate market also prohibits short selling which is common in the securities market. This
leads to most outcomes resulting in a decrease in the speed of price adjustments, and an upward
bias of prices above the mean evaluation. Research to date is thin and has produced mixed
evidence due to the single-index equilibrium models like the CAPM being inadequate. It is
suspected that we will eventually arrive at a conclusion that the real estate market is
‘operationally efficient’ meaning that while excess returns are not the rule, they are available
frequently enough to provide rewards for those whose efforts keep the market as efficient as it
may be. (Lusht, 1988) Relaxing the CAPM assumptions lead to a separate pricing paradigm for
financial assets, income-producing real estate and owner-occupied housing respectively, that a
‘dividend effect’ arises for real estate as the result of illiquidity, and that illiquidity reduces the
extent to which investors hold real estate in their portfolios. (Liu, Grissom, & Hartzell, 1990)

CONCLUSION
In conclusion, we accept the notion that CAPM is already functioning in the Chinese
financial market and it has particularly stood the test of time in Shanghai. However, CAPMs
inherent assumptions do not bode well in the Chinese financial market since it is not perfect, to
begin with, the costs of transactions are much higher in China than its western mature
contemporaries and this is due to a high amount of non-negotiable stocks. It is difficult to find
out an appropriate index as a proxy of market portfolio (Gao Yan, & Yang Xin, 2018) coupled
with the Chinese financial market still being a novice makes it harder to reach a definitive
conclusion from the statistical data stemming from a small pool of selected stocks and the overall
“policy-driven” status of the Chinese stock market.
Real estate as a market cannot rely on static equilibrium models which are based upon
finance to yield returns, due to the illiquidity of the real estate, systematic mispricing is observed,
this results in an illiquidity premium and dividend effect. The real estate in China lacks research
and data which makes it a black box for a researcher observing the behavior with a model which
is based on various assumptions not valid in certain situations. The research has produced mixed
evidence, however, there will eventually be a conclusion that the real estate market is
operationally efficient.
In performing this research various limitations hindered the results. These limitations
include, papers chosen relying on a small number of specific stocks, these stocks are also
relatively young compared to other stocks in various locations around the world. The data for the
CAPM in China

CAPM as a model in real estate was however not present in most cases or lacks literature
published in adequate journals, hence a concrete conclusion cannot be reached.
CAPM in China

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