The Journal of Financial Research.

Pages 523-543 Winter 2001

Vol. XXIV, NO.4.

STOCK RETURNS AND VOLATILITY

ON CHINA'S STOCK MARKETS

Cheng F. Lee
The State University of New Jersey, Rutgers

Gong-meng Chen and Oliver M. Rui

Hong Kong Polytechnic University

Abstract
\Ve exam me time-series features of stock returns and volatility, as well
as the relation between return and volatility in four of China's stock exchanges.
Variance ratio tests reject the hypothesis that stock returns follow a random walk.
We find evidence of long memory of returns. Application of GARCH and
EGARCH models provides strong evidence of time-varying volatility and shows
volatility is highly persistent and predictable. The results of GARCH-M do not
show any relation between expected returns and expected risk. Daily trading
volume used as a proxy for information arrival time has no significant explanatory
power for the conditional volatility of daily returns.

JEL classification: G 15

I. Introduction
Harvey (1995) reports that emerging markets have high average returns, low
overall volatility, low exposure to world risk factors, and little integration. He
concludes that emerging markets are less efficient than developed markets and that
higher return and lower risk can be obtained by incorporating emerging market
stocks in investors' portfolios. From a U.S.-based investor's point of view, it is
important to understand the potential portfolio implications of investing in stocks
in these countries. Additionally, it is desirable to understand the behavior of the
major equity performance indicators for these countries over time.
China's stock markets attract foreign investors' attention because of that
country's fast development and potential opportunities. Since the establishment of
the Shanghai Stock Exchange on December 19, 1990, and the Shenzhen Stock

We would like to thank an anonymous reviewer and William T. Moore, the editor of the Journal of
Financial Research, for their helpful comments and suggestions. Financial support provided by a grant from
the Departmental Research Grant of Hong Kong Polytechnic University (Account No. A-PA 87) is gratefully
acknowledged.

523

524

The Journal of Financial Research

Exchange on July 3, 1991, China's stock markets have expanded rapidly.' By

December 31, 1997, China had 720 A-share listed stocks, of which 372 traded on
Shanghai and 348 traded on Shenzhen, and 101 B-share listed stocks, of which 50
traded on Shanghai and 51 traded on Shenzhen. A-share stocks are traded among
Chinese citizens and B-share stocks are traded among non-Chinese citizens or
overseas Chinese.' Total market capitalization exceeds $200 billion, or nearly onefifth of the country's gross domestic product. Daily trading volume typically hits
750 million shares. China will, therefore, provide a major investment avenue for
international and global investors after its accession to the World Trade
Organization (WTO). One concern international investors have, however, is the lack
of knowledge of China's markets. Institutional characteristics of China's markets
differ from those in other countries, so that the research results from other countries
cannot be automatically extended to China. One distinguishing feature of China's
markets is that some shares are restricted to domestic investors and others are
restricted to foreign investors.
In this study we characterize the dynamics of stock returns and conditional
volatility in China's stock exchanges. We focus on whether stock returns follow the
random walk hypothesis in China. Also, we examine whether stock return volatility
changes over time and whether it is predictable. We then study the relation between
market risk and expected return. Finally, we examine whether daily trading volume
used as a proxy for information arrival time has significant explanatory power for
the conditional volatility of daily returns.
Many studies examine whether stock returns are predictable from the past.
One hypothesis widely tested is that stock prices follow a random walk, which
implies returns are independent. Lo and MacKinlay (1988) and Poterba and
Summers (1988) provide empirical evidence against the random walk hypothesis for
stock returns in the U.S. stock markets. Recently, the attention of research has
shifted to recognizing the possibility of long-term dependence of returns. Lo (1991)
conducts long-memory analysis for stock prices.
Financial economists study returns and conditional volatility of stock
markets extensively. Baillie and DeGennaro (1990) study the dynamics of expected
stock returns and volatility in the U.S. stock markets; Poon and Taylor (1992)
investigate the same relation in the U.K. stock market. Both studies find clustering,
predictability, and persistence in conditional volatility in these markets. Conditional
second moments playa key role in various financial activities. Many asset pricing
models predict that the expected return of any asset is directly related to its
covariance with one or more pricing factors. Most portfolio-diversification and risk'The Shanghai and Shenzhen stock exchanges are self-regulated and cross-listing is not allowed. In the
Shanghai Exchange, orders are automatically matched on a time-price priority basis, whereas in the Shenzhen
Exchange, orders are matched on a price-time-order priority basis.
'For the purpose ofB shares on the Shanghai and Shenzhen exchanges, overseas investors are described
as: foreign legal and natural persons; legal and natural persons from Hong Kong, Macau, and Taiwan; and
other investors approved by the People's Bank of China.

China's Stock Markets

525

hedging strategies are based on the ability to predict variance and covariance. The
evidence on non-U.S. markets is limited. Therefore, investigating China's stock
market, which has different economic, institutional, and microstructural features,
becomes appealing to academies and practitioners. The investigation of returns and
the conditional volatility of China's stock markets provides an opportunity to add
to the evidence.
We find that the variance ratio test rejects the random walk hypothesis. The
fractional differencing test for long memory devised by Geweke and Porter-Hudak
(1983) is employed to detect long memory in stock returns in China's stockmarkets.
This test provides support for long memory. The generalized autoregressive
conditionally heteroskedastic (GARCH) and the exponential generalized
autoregressive conditionally heteroskedastic (EGARCH) models are used to obtain
appropriate series of conditional variances that can be used as expected volatility
estimates. We find strong evidence of time-varying volatility and clustering of
high/low volatility. We also find that volatility shows high persistence and is
predictable. In addition, we find support for a fat-tailed conditional distribution of
returns, which implies that large changes in speculative prices are expected
relatively often. To examine the relation between expected returns and expected
volatility, we fit the generalized autoregressive conditionally heteroskedastic in the
mean (GARCH-M) model. We do not find any relation between expected returns
and expected risk as predicted by asset pricing models. Finally, using daily trading
volume as a proxy for information arrival time does not have significant explanatory
power for the conditional volatility of daily returns.
II. Background on China's Stock Markets
Capital markets in China have experienced tremendous development over
the past decade. The inception of a shareholding system in China dates from 1979.
In the early stages, stocks had many of the characteristics of bonds and little
similarity to the traditional concept of stocks in Western capitalist economies. They
usually were characterized by a fixed income with a fixed maturity and were issued
to raise funds for specific investments. Initially, these stocks were issued mainly to
corporate employees. The development ofa primary share market began in 1984,
when enterprises were first allowed to raise funds by issuing stocks. A secondary
trading market was initiated in 1986 but was not fully developed until 1988, when
the government first allowed state treasury bills to be openly traded in five major
cities. Since 1988, there has been rapid progress in the development of a diversified
securities market. Between mid 1988 and late 1990, trading in government and
corporate securities became common, and the official secondary market for state
treasury bills was extended across China. By December 1997,782 stocks were listed
on the two exchanges, with a total market capitalization of more than RMB 1,200
billion (Chinese currency), equivalent to about US$140 billion.

526

The Journal of Financial Research

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China's Stock Markets

527

We use daily returns from December 12, 1990, to December 31,1997, for
the Shanghai A Index; from February 21, 1992, to December 31, 1997, for the
Shanghai B Index; from September 30, 1992, to December 31, 1997, for the
Shenzhen A Index; and from October 6, 1992, to December 31, 1997, for the
Shenzhen B Index. The Shanghai and Shenzhen stock exchanges provide us with all
the data. The Shanghai Stock Exchange, founded on November 26, 1990, began
trading securities on December 19 of that year. The Shanghai Securities Exchange
Index is a weighted-average, market-capitalization index. Its base date is December
19, 1990, and its base value is 100. The index comprises all listed shares. The
Shenzhen Stock Exchange has been operating since December 1, 1990. The
Shenzhen Securities ExchangeIndex isalso a value-weighted (VW) average marketcapitalization index. To control for the well-documented size effect and
nonsynchronized trading, we also use an equally weighted (EW) index of both stock
markets.
III. Empirical Design and Results
Descriptive Statistics
Table 1 provides summary statistics for all stock return series in both the
Shanghai and Shenzhen stock exchanges. The statistics show that returns are
positively skewed although the skewness statistics are not large. The positive
skewness implies that the return distributions of the shares traded on these
exchanges have a higher probability of earning positive returns. All the kurtosis
values are much larger than 3. This shows that for all series, the distribution of
returns has fat tails compared with the normal distribution. Cartwright and Lee
(1987) investigate the effects of temporal aggregation on the existence of a dynamic
market model and on the magnitude of beta estimates. They find that temporal
aggregation does affect the specification of the market model and beta estimates. To
control for the potential time aggregation effect, we also analyze the weekly and
monthly data.'
Autocorrelation coefficientsare reported in Table 2. Autocorrelation reflects
how quickly and completely stock prices adjust to new information. Whereas
positive autocorrelation suggests a slow and partial price adjustment, negative
autocorrelation suggests overreaction. The autocorrelation coefficients for return
series ofB-share stocks have higher values than the autocorrelation coefficients for
those of A-share stocks. Significant autocorrelation is detected at a lag of one period
for return series of B-share stocks in the Shanghai and Shenzhen stock markets.
Most of the dependence may be due to thin trading. B shares account for less than
5 percent of the total market capitalization. Also, B-share markets have been

3The results for weekly and monthly data are available upon request.

The Journal of Financial Research

528

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China's Stock Markets

529

illiquid and less active than A-share markets, as shown by the average turnover rate
in B-share markets hovering around one-tenth ofthat in A-share markets. Ljung-Box
statistics provide evidence of possible dependence in the first and higher moments
of the return distributions. Under the null hypothesis of no serial correlation, the Qstatistics are distributed asymptotically chi-squared with m degrees of freedom. The
results show that the independent and identically distributed hypothesis is rejected
for all the stock return series in China. This is consistent with the results of the
following variance ratio test where the random walk hypothesis is rejected.
The autocorrelation coefficients of returns suggest a slowly decaying
autoregressive effect. We test the unit root of returns and report the results in Panel
B of Table 2. The null hypothesis of a unit root is rejected. On the basis of the
results of the unit root test, we fit returns using the ARMA(1 ,1) model. 4

Testing the Random Walk Model Using Variance Ratio Tests

To test for the random walk in returns on China's stock markets, we follow
the procedure used by Lo and MacKinlay (1988) to test for an Ito process in stock
returns. The idea behind the variance ratio test is that if the return series is a pure
random walk, the variance of its n-differences grows proportionally with the
difference n, Lo and MacKinlay examine the random walk hypothesis hy testing the
null hypothesis that the variance ratio is given by:

VR(n) = lif(n)
nif(l)

1,

(1)

where den) is an unbiased estimator of the variance of the nth difference of return
r" and er( 1) is the estimator of the variance of the first difference of r,.
We reject the hypothesis of a random walk by using the autocorrelation test
and the Dicky-Fuller unit root test, but these results are justified only if the
underlying variables are normally distributed. Table 1 documents that the
distribution exhibits excess kurtosis relative to a normal distribution. Lo and
MacKinlay (1988) show that the variance ratio test is more powerful than the BoxPierce Q-test and the Dicky-Fuller unit root test against several alternative
hypotheses. A variance ratio less than unity indicates the presence of negative serial
correlation, which is consistent with mean-reverting behavior in the series. A
variance ratio greater than unity indicates the presence of positive serial correlation
or an explosive function in the series. Lo and MacKin lay derive an asymptotic
standard normal test statistic, Z, that provides the statistical significance of the

'The parameter estimates and the descriptive statistics for fitted values are available on request. We find
the fitted values are highly skewed and have large kurtosis coefficients.

The Journal of Financial Research

530

TABLE 3. Results of Variance-Ratio Tests.

Returns
Shanghai A
EW Return
Shanghai A
VW Return
Shanghai B
EW Return
Shanghai B
VWRetum
Shenzhen A
EWRetum
Shenzhen A
VWReturn
Shenzhen B
EWRetum
Shenzhen B
VWRetum

No. (N)
ofObs.
1767
1767
1470
1470
1295
1640
1759
1406

No. (n) of Multiple Sampling Periods

Used to Generate Variance Ratio
4
8

2
0.0341
(20.1043)
0.3344
(17.2371)
0.4726
(16.2966)
0.4646
(16.3018)
0.3395
(J8.0585)
0.3339
(20.3598)
0.4041
(17.8018)
0.4414
(18.7830)

0.2047
(16.3760)
0.1994
(16.3443)
0.2717
( 14.8470)
0.2669
(14.9944)
0.1964
(14.0286)
0.1972
(157760)
0.25i!
(13.7967)
0.2812
(14.5699)

0.1160
(12.2105)
0.1119
(12.1630)
0.1532
(11.1014)
0.1488
(ll.1045)
0.1129
(10.4537)
0.1086
(11.8043)
0.1466
(l0.2517)
0.1637
(10.8411)

16
0.0625
(8.9286)
0.0617
(8.9420)
0.0833
(7.9333)
0.0809
(8.0900)
0.0606
(7.5750)
0.0601
(8.5857)
0.0736
(7.5102)
0.0834
(7.9429)

Note: The variance ratio is given by:

VR(n)

1a2(n)
na2(1)

1,

where o2(n) is an unbiased estimator of the variance of the n'" difference of return r.; and 02( 1) is the estimator
of the variance of the first difference of r..

variance ratios, as well as an alternative statisnc, Z*, that is robust to

heteroskedasticity and nonnorrnal disturbances.
We calculate the standard VR(n) andZ(n), where n represents multiples of
each series. The results are presented in Table 3. The variance ratios are reported in
the main rows of the table, and the Z-statistics are given in parentheses below each
entry. The variance ratio estimates in Table 3 are less than unity for all n, and the
ratios decrease with increasing n. Under the hypothesis of homoskedasticity, the
random walk hypothesis is rejected for all stock return series. For example, the Zstatistics for the Shanghai VW returns for n = 2,4,8, and 16 are 17.2371, 16.3443,
12.1630, and 8.9420, respectively. All four Z-statistics indicate the random walk
hypothesis is rejected for the Shanghai VW return for all four intervals examined.
Bya similar analysis, the remaining Z-statistics in Table 3 present evidence rejecting
the random walk hypothesis in the remaining seven return series on the Shanghai
and Shenzhen stock exchanges.
The rejection of the random walk for returns on China's stock markets may
be due to heteroskedasticity or serial correlation. To further investigate the time
behavior of returns, we employ a heteroskedasticity-consistent variance ratio test
with the statistics Z*(n). Because the results are identical to the homoskedasticity-

China's Stock Markets

531

consistent results, we do not report them. This finding suggests that the rejection of
the random walk may be due to serial correlation. The overall results from variance
ratio and Box-Pierce tests provide evidence rejecting the random walk hypothesis
for stock returns in China.
Because the rejections obtained from the variance ratio test are robust to
heteroskedasticity, they suggest autocorrelation. The existence of autocorrelation in
financial assets does not necessarily imply market inefficiency. The reasons offered
for such dependencies include information asymmetries and the competencedifficulty gap. Poterba and Summers (1988) suggest some alternatives to the random
walk. The alternatives are a mean-reverting process, the sum of a random walk, and
a stationary mean-reverting process. These alternatives imply that prices and returns
are negatively serially correlated and that the serial correlation becomes more
negative as the holding period increases. If such processes govern returns, the
variance ratios should be less than unity for long horizons. Our results support the
mean-reverting hypothesis. The presence of negative serial correlation in return
series may also be linked to thin trading.
Long Memory of Return Series
A cornmon statistical alternative to the random walk is long-term memory.
Long memory describes the correlation structure of that series at long lags. If a
series exhibits long memory, there is persistent temporal dependence among
distance observations. The potential existence of long-term dependence in stock
returns has important consequences for financial theory. A growing body of
literature explores the long-memory property of financial price series. For example,
Poterba and Summers (1988) report that stock returns display positive correlation
over short horizons and negative correlation over long horizons. The long-term
memory property of the mean-reverting model of stock returns implies that stock
returns are negatively serially correlated, and that the negative serial correlation
becomes more severe as the length of the holding period increases. Lo (1991)
attributes this observation to the possible presence of long cycles and potentially
predictable components in long-horizon stock returns. We employ the fractional
differencing test for long memory devised by Geweke and Porter-Hudak (1983) to
detect long memory. The fractional differencing approach models long-memory
dynamics parametrically. Under this approach, whether a series displays long
memory depends on a fractional differencing parameter, which is subject to
estimation and hypothesis testing. A general class of the long-memory process is
described by an autoregressive fractionally integrated moving average (ARFIMA)
model,
(2)

where B(L) and C(L) are polynomials in the lag operator L, and (l - L/ is the
fractional differencing operator defined by:

532

The Journal of Financial Research

(1 - L)d

i:: I'(f(k -

k=O

d)L k ,
-d)f(k + 1)

(3)

where f is the Gamma function. The fractional parameter given by d assumes any
real value. When d E (0, 0.5), the ARFIMA process is said to exhibit long memory;
when d EO ( -0.5, 0), the process exhibits intermediate memory; and when d = 0, the
process exhibits short memory. When d EO (0.5, 1), the process is mean reverting
because there is no long-run effect of an innovation on future values of the process.
A spectral method suggested by Geweke and Porter-Hudak (1983) can be used to
estimate the fractional parameter d. The spectral regression is defined by:

In(I(SJ) " ~o '

~I ~

sin' [ ;))

+ ~"

l. c 1, ... , v,

(4)

where

denotes the harmonic ordinates of the sample, T is the number of observations, and
n = T ~for 0 < r.t < 1 is the number of low- frequency ordinates used in the regression.
In the spectral procedure, the number of low-frequency ordinates, n, involves
judgment. Although a large value of n will cause contamination of the d estimate
because of medium- or high- frequency components, a small value of n will lead to
imprecise estimates because of limited degrees of freedom in estimation. We
estimate the fractional parameter d for r.t = 0.5, 0.55, and 0.6.
We report the estimates for the fractional parameter d in Table 4. Almost all
of the d estimates are within the range of 0 and 0.5, suggesting long memory. Four
estimates are within the range of -0.5 and 0, implying intermediate memory. The
evidence supports long memory in both the Shanghai and the Shenzhen markets.

Volatility Estimates Using GARCH Models

Security returns in China's stock markets do not follow random walks. This
may be due to the strong assumption that the entire underlying probability
distribution of returns remains stationary through time. It is reasonable to believe
that because of changes in the risk of a firm, the variance of stock returns will
change over time. Financial economists show the autoregressive conditional
heteroskedasticity (ARCH) process provides a good fit for many financial return
time series. The ARCH model allows the conditional variance to change over time
as a function of past squared errors. The strength of the ARCH technique is that the
conditional means and variances can be estimated jointly using traditional specified

533

China's Stock Markets

TABLE 4. Results of Fractional Differencing Analysis.
Returns
Shanghai A
EWReturn
Shanghai A
VW Return
Shanghai B
EWReturn
Shanghai B
VWReturn
Shenzhen A
EWRetum
Shenzhen A
VW Return
Shenzhen B
EWReturn
Shenzhen B
VWReturn

No. (N)
ofObs.
1767
1767
1470
1470
1295
1640
1759
1406

= r=
(d)

n = T05s

0.017
(0.157)
0.076
(0.666)
0.019
(0.159)
0.064
(0.528)
0.111
(0.892)
0.152
(1.301)
0.119
(0.935)
-0.078
(-0.637)

0.053
(0.579)
0.081
(0.886)
-0.020
(0.208)
-0.022
(-0.235)
0.003
(0.003)
0.133
(1.413)
0.103
( 1.007)
-0.038
(-0.382)

(d)

n=

rO.6

(d)
0.011
(0.151)
0.081
( 1.086)
0.048
(0.612)
0.059
(0.746)
0.032
(0.395)
0.101
(1.319)
0.105
(1.251)
0.003
(0.035)

Note: The spectral fractional lest for long memory suggested by Geweke, Porter, and Hudak (1983) is
performed on the stock return series for both Shanghai and Shenzhen stock markets. The figures in
parentheses are the r-statistics for the corresponding fractional parameter d-estimates.

models for economic variables. ARCH imposes an autoregressive structure on

conditional variance, allowing volatility shocks to persist over time. This persistence
captures the propensity of returns of like magnitude to cluster in time and can
explain the well-documented nonnormality and instability of empirical asset return
distributions.
Engle, Ito, and Lin (1990) provide two possible explanations for volatility
clustering. First, if information arrives in clusters, returns may exhibit clustering.
Nominal interest rate, dividend yield, money supply, oil price, margin requirement,
business cycles, and information patterns are the sources of volatility clustering.
Second, if participants have different prior beliefs and take time to digest the
information shocks and to resolve their expectation differences, market dynamics
can lead to volatility clustering.
Bollerslev ( 1986)extends the ARCH process to GARCH, which allows for
a more flexible lag structure. He shows that the extension of the ARCH process is
much like the extension of the standard time-series process to a general ARMA
model. The GARCH( 1,1) model for daily stock return is given below:

(5)

534

The Journal of Financial Research

In (5), rt represents the rate of return, I, I is the set of information available at the
beginning of time t, and the conditional density function is modeled as a generalized
error distribution (GED). The br.; component is included in the mean equation to
account for the autocorrelation potentially induced by nonsynchronous trading in the
assets that make up a market index. This problem can be particularly severe in
emerging markets, such as China, given their low level of liquidity. The choice of
GED density is dictated by the inability of Gaussian GARCH processes to account
for leptokurtosis in most return series, an issue that is likely to be even more relevant
when using emerging market data. The GED distribution is written as follows:
vexp[ -(l/2)letht~1/2n,r]
----------ht
A.2[(v+
l)lv]r (lIv)

-112
,where

A.

[2(~2/v)r(lIv)1112
co

r (3/v)

(6)

In (6), I'(.) is the gamma function and v is a measure of tail thickness, which is equal
to 2 for the normal density and less than 2 for the leptokurtic distribution. If the
parameters of the lag polynomials a and p are positive, shocks to volatility persist
over time. The degree of persistence is determined by the magnitude of these
parameters. If the magnitude of this sum is close to unity, the process is said to be
integrated in variance, where the current information remains important for the
forecasts of the conditional variance for all horizons.
Table 5 contains parameter estimates. At first glance, the results are
consistent with those of other empirical works on time-varying volatility. First, the
likelihood ratio statistics are large, which implies the GARCH model is an attractive
representation of daily return behavior, successfully capturing the temporal
dependence of volatility. Second, the GARCH parameterization is statistically
significant. Third, most of the estimated P coefficients in the conditional variance
equation are considerably larger than the a coefficients. This implies that large
market surprises induce relatively small revisions in future volatility. Finally, the
persistence of the conditional variance process, measured by a + p, is high and often
close to the integrated GARCH model of Engle and Bollerslev (1986). This implies
current information is also relevant in predicting future volatility at a long horizon.
We report point estimates of the tail-thickness parameter v and compute a
one-sided test against the alternative hypothesis that the parameter is less than 2, the
benchmark value for normal density. In all instances the null hypothesis of
normality is strongly rejected. This implies China's stock markets are more likely
to be affected by big surprises, conditional on information available at any time.
China's stock markets are some of the world's most volatile markets, with shares
routinely moving by their 10 percent daily limit.
We report the Ljung-Box statistics for 24th-order serial correlation in the
level and squared standardized residuals as well as the asymmetry test statistics (sign
bias, negative size, positive size, andjoint tests) developed by Engle and Ng (1993).
The latter is included because the findings by Engle and Ng suggest the Ljung-Box

535

China's Stock Markets

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test may not have much power in detecting misspecifications related to asymmetric
effects. Both the Ljung-Box and asymmetry checks indicate the estimated models
fit the data well.
Nelson (1991) develops the EGARCH model. EGARCH has certain
advantages over GARCH. First, by using the exponential formulation, the
restrictions of positive constraints on the estimated coefficients in ARCH and
GARCH are no longer necessary. Second, a weakness of the GARCH model is that
the conditional variance depends on the magnitude of the disturbance term, but not
its sign. GARCH fails to capture the negative asymmetry apparent in many financial
time series. The EGARCH model ameliorates this problem by allowing for the
standardized residual as a moving average regressor in the variance equation, while
preserving the estimation of the magnitude effect. Additionally, the ARCH/GARCH
approach to modeling changing volatility precludes the testing of the leverage effect.
The tendency for negative shocks to be associated with increased volatility is
captured in the ARCH/GARCH class of models.
If the sum of the parameters of the lag polynomials a and b equals I in the
GARCH(l,l) process, the model is known as integrated GARCH, or IGARCH,
which implies persistence in the forecast of the conditional variance over all future
horizons and implies an infinite variance for the unconditional distribution. The
presence of the near-integrated GARCH being close to but slightly less than unity
is found in several financial market series (e.g., Bollerslev (1986)). We employ the
following EGARCH(l, I) model to estimate stock return volatility:
rt = a

lnh

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(7)

The results of the EGARCH model are reported in Table 6. The leverage
factory is positive for EW returns of Shanghai A-share stocks, whereas the leverage
factors yare negative for both EW and VW returns ofShenzhen B-share stocks. The
leverage factors for other return series are mixed and not statistically significant.
The results do not support the negative leverage factors suggested by Nelson (1991).
The likelihood ratio of the EGARCH model is not larger than that ofGARCH. This
result shows that the EGARCH model with a leverage factor does not produce a
better description of the data than GARCH.

China's Stock Markets

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538

The Journal of Financial Research

Relation Between Expected Returns and Expected Conditional Variance in the

GARCH-M Models

The capital asset pricing model and arbitrage pricing theory provide a
theoretical foundation for the positive relation between risk and return. In theory,
risk is measured by the conditional covariance of returns with the market. Most
previous empirical studies use the actual return and risk based on the unconditional
distribution of return. We employ GARCH-M to investigate the effect of volatility
on the return-generation process. Application of the GARCH-M model to testing
capital asset pricing theories presents an improvement in specification of asset
pricing models because it allows measurement of the conditional variance of returns
as the measure of risk. This framework discards the restrictive assumptions of
linearity, independence, and constant conditional variance. The volatility measure
defined by the conditional variance in the GARCH model is an expectation
formulation. This volatility measure may be influenced by it own past values and
past values of the return series. If these forecasts of variance can be used in an
efficient market to predict expected returns, we should expect c in the following
GARCH-M formulation to be positive for a risk-averse investor:

(8)
We study whether investors in China's stock markets are rewarded for their
exposure to high levels of volatility by using the GARCH-M model. The results are
shown in Table 7. The coefficient estimates that link first and second moments can
be interpreted as a measure of the price of risk. We expect a positive relation
between conditional expected returns and conditional market volatility. Instead, we
find a negative relation between expected returns and conditional volatility in
Shanghai A-share stocks, and the coefficient estimates are significant. The relations
between expected return and conditional volatility in the Shanghai B-share and
Shenzhen A-share and B-share markets are mixed and not significant. To capture
the negative asymmetry, we employ the EGARCH(l, 1)-M model to estimate the
relation between expected returns and expected conditional variance. We observe
the same results as those for the GARCH-M model.'
'The results of the EGARCH-M model are available on request. There is a negative relation between
expected return and conditional volatility in Shanghai A-share stocks, and the estimated coefficients are
statistically significant. The relations between expected return and conditional volatility in Shanghai B-share
and Shenzhen A-share and Bvshare stocks are mixed and not significant. The leverage factory is positive for
EW returns of Shanghai A-share stocks and negative for both EW and VW returns of Shenzhen Bvshare
stocks. The leverage factors for other return series arc mixed and not significant.

539

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It appears that an increase in the conditional volatility of returns is not

important in explaining returns in China. This finding is consistent with the results
of Poon and Taylor (1992) for U.K. data and of Baillie and DeGennaro (1990) for
U.S. data, where evidence suggests that variables other than volatility estimates are
used when formulating expected returns.

Information Flow and Volatility

To examine the hypothesis that the flow of information to the market helps
explain the volatility of returns, we use trading volume as a proxy for information
innovations. Autocorrelation in the time-varying rate of information arrival leads to
time-series dependencies in conditional volatility that are accounted for by GARCH
models. This explanation is rooted in a class of theoretical models where trading
volume and price volatility are driven by exogenous information innovations.
Lamoureux and Lastrapes (1990) used this framework to test whether GARCH
effects remain after the conditional volatility specification expands to include
contemporaneous trading volume as a proxy for information arrival. They find that
for individual stocks, volatility persistence falls significantly once contemporaneous
trading volume is included.
We choose daily trading volume as a measure of the amount of daily
information that flows into the market. The model to be estimated is given by the
following equations:

(9)
The mixture model predicts that X > O. Furthermore, in the presence of
volume with X > 0, a and ~ will be small and not significant if daily volume is
serially correlated. In particular, the persistence of variance as measured by (a + ~)
should become negligible if accounting for the uneven flow of information explains
the presence of GARCH in the data.
The GARCH coefficients a and ~, shown in Table 8, are significant for
return series in China's stock markets. The sums (a + ~) are fairly close to 1,
indicating the persistence of past volatility in explaining current price volatility. We
examine the X coefficients and compare the results with the output from our
constrained model where conditional variance is modeled as a function of only past
errors and past variances. If observed GARCH effects tend to disappear when
unexpected innovations in market value are included in the model, this suggests
observed persistence in returns might be at least partially explained by information

China's Stock Markets

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The Journal of Financial Research

arrival. The GARCH effect remains significant when volume is included in the
model; however, the persistence in volatility as measured by (a + P) is marginally
smaller when volume is included in the model. These results may suggest that
lagged squared residuals still contribute much when there is additional information
about the variance of the stock return process after accounting for the rate of
information flow, as measured by contemporaneous volume.
Najand and Yung (1991) and Bessembinder and Seguin (1993) also test for
the relation between a proxy for information arrival and GARCH effects. They note
an important specification issue is implicit in including the contemporaneous
volume variable in the conditional volatility specification of a GARCH model.
Strictly speaking, inferences can be made only if volume is exogenous. However,
in the mixture of distribution model, volume and price changes are a joint function
of information arrival. Whether this is the case, estimates based on such a
specification could have an unquantified bias.
Najand and Yung (1991) address this simultaneity problem by using lagged
volume, which may be treated as a predeterrnined variable. They find that with
lagged volume the GARCH effect is consistently significant in all calendar periods,
and they observe a statistically meaningful positive correlation between price
variability and volume for their sample. Bessembinder and Seguin (1993)
demonstrate, over a range of different futures contracts, that the conditional
volatility exhibits strong persistence even when unexpected and expected volume
and open interest are included in the specification. These results are at odds with
those of Lamoureux and Lastrapes (1991).
To overcome the simultaneity problem, we reestimate (9) with lagged values
of volume (Vt_1).6 We find that the estimated GARCH coefficients a and pare
statistically significant for return series in China's stock markets. The sums (a + P)
are fairly close to I, indicating the persistence of past volatility in explaining current
return volatility. The GARCH effect remains significant when lagged volume is
included in the model; however, the persistence in volatility as measured by (a + P)
is still marginally smaller when volume is included. Trading volume as a proxy for
information innovations does not help explain the volatility of returns.

IV. Conclusion
We find that the variance ratio test rejects the random walk hypothesis.
Stock returns are not independent and identically distributed in China. The
alternative to the random walk is a mean-reverting process, which implies that prices
and returns are negatively serially correlated and that the negative serial correlation
becomes more severe as the holding period increases. If such processes govern
returns, the variance ratios should be less than unity for long horizons.

6The results are available on request.

China's Stock Markets

543

Our results support the mean-reverting hypothesis. The presence of negative

serial correlation in return series may also be linked to thin trading. To test for long
memory in stock returns in China's stock markets, we employ the fractional
differencing test for long memory devised by Geweke and Porter-Hudak (1983).
There is some evidence of long memory, which suggests possibilities for
constructing nonlinear econometric models for improving price forecasting
performance. GARCH and EGARCH models are used to obtain appropriate series
of conditional variances that can be used as expected volatility estimates. We find
strong evidence of time-varying volatility. We also find that periods of high and low
volatility tend to cluster. Also, volatility shows high persistence and is predictable.
Evidence in support of a fat-tailed conditional distribution of returns is found,
implying that large changes in speculative prices are expected relatively often. We
examine the relation between expected returns and expected volatility by fitting the
GARCH-M model and do not find a relation between expected returns and expected
risk as predicted by asset pricing models. This suggests variables other than
volatility estimates should be used when formulating expected returns in China. We
do not find daily trading volume used as a proxy for information arrival time has
significant explanatory power regarding the conditional volatility of daily returns.
Most of the findings are consistent with those documented for mature markets.
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