Problem 1

a.
Data Preprocessing:
Stock Returns and Market Capitalization
The dataset consists of individual stock returns (Return) and market
capitalization (Market_Cap) for A-share stocks listed on the Shanghai Stock
Exchange. Missing values in the return column were forward-filled, missing values in
the Cap column were forward-filled and backward-filled to ensure continuity.

Earning-to-Price Ratio:
The Earning-to-Price ratio (EP_Ratio) was calculated based on daily data.
Replace the ep of that month with mean value. And missing values were filled using a
forward and backward fill strategy.

Factor Construction:
Size Factor (SMB)
The Size factor was constructed by sorting stocks by market capitalization and
forming portfolios based on the remaining upper 70% of stocks.
Value Factor (VMG)
The Value factor was constructed using the Earning-to-Price ratio, dividing stocks
into growth, mid, and value portfolios.
Market Factor (MKT)
The Market factor (MKT) represents the return on the top 70% of stocks by
market capitalization, weighted by their respective market caps.

The detail process is ‘First, we eliminate the smallest 30% of stocks, to avoid
their shell-value contamination, and we use the remaining stocks to form factors.
Second, we construct our value factor based on EP. Otherwise, we follow the
procedure used by Fama and French (1993). Specifically, each month we separate the
remaining 70% of stocks into two size groups, small (S) and big (B), split at the
median market value of that universe. We also break that universe into three EP
groups: top 30% (value, V), middle 40% (middle, M), and bottom 30% (growth,
G). We then use the intersections of those groups to form value-weighted portfolios
for the six resulting size-EP combinations: S/V, S/M, S/G, B/V, B/M, and B/G. When
forming value-weighted portfolios, here and throughout the study, we weight each
stock by the market capitalization of all its outstanding A shares, including
nontradable shares. Our size and value factors, denoted as SMB (small-minus-big)
and VMG (value-minusgrowth), combine the returns on these six portfolios as
follows:
SMB = 1/3 (S/V + S/M + S/G) – 1/3 (B/V + B/M + B/G),
VMG = 1/2 (S/V + B/V) – 1/2 (S/G + B/G).
 The market factor, MKT, is the return on the value-weighted portfolio of our
universe, the top 70% of stocks, in excess of the one-year deposit interest rate.’ from
the paper.

Performances:
 Annualized Return: Calculated as the Compound Annual Growth Rate (CAGR)
of the factor returns.
 Annualized Volatility: Calculated as the standard deviation of the factor returns,
annualized by multiplying it by √ 12 (number of months in a year).
 Skewness: Calculated as the skewness of the factor returns.
 Winning Percentage: Calculated as the percentage of months with positive factor
returns.

Results:

b.
Constructing portfolios based on extreme percentiles facilitates capturing the spread

in returns between stocks with high and low market capitalization or EP ratios. Form
long portfolios with the top ten percent and short portfolios with the bottom ten
percent.
Use CAPM model and CH-3 factor model to explain these two anomalies

I also create some functions for reproducing the first two rows of Panel A in Tables 6
and 7 in Liu, Stambaugh and Yuan (2019) article.
(Focusing on alpha, beta and the corresponding t-values)

Conclusions:
The negative t-value for β may suggest a potential reversal effect. Both CAPM and
the CH3 model suggest the presence of significant anomalies in the market. Market
Cap Anomaly is consistently significant across models, indicating abnormal returns
related to market capitalization. EP Anomaly shows mixed results, with significance
in some factors and lack of significance in others, suggesting a complex relationship
with market and size factors.

c.
Download three-factor model in CSMAR, and filter the data: Market type =
P9701(SSE A-share stocks). Do correlations of three-factor model I constructed and
three-factor model in CSMAR. We get:
Three-factor model in (a):

VMG and SMB

Three-factor model in CSMAR:
Weighted Average of Total Market Value
Weighted Average Value of Negotiable Shares

d.
Repeat Construct Market cap anomaly and EP anomaly, use CAPM model and CH-3
factor model to explain these two anomalies:

Not consistent
 Policy Impact: The IPO policy changes, particularly the implementation of the
full registration system, may have led to increased ease for smaller firms to gain
capital. This could result in more efficient market information and reduced
frictions, affecting the explanatory power of size and value factors.
 Size-Value Dynamics: The weakening explanation of size and value factors in
the CH3 model aligns with the notion that smaller firms can now access capital
more efficiently. Consequently, market dynamics may reflect this change,
altering the traditional relationships between firm size, value, and abnormal
returns.