Financial risk, uncertainty and expected returns: evidence from Chinese equity markets

Abstract

Purpose The purpose of this paper is to investigate the risk and economic policy uncertainty (EPU) shocks on China’s equity markets while controlling for changes in sentiments and liquidity. Design/methodology/approach The GED-TARCH(1,1)-M procedure is used in estimations to deal with the heteroscedasticity problem. Findings Evidence shows that stock returns are positively correlated with predictable volatility and lagged downside risk. This study indicates that the stock returns are negatively correlated with both local and global uncertainty innovations. The test results are robust across different measures of stock returns and model specifications. The global EPU innovations have more profound impact on stock returns than that of Chinese EPU. Research limitations/implications The findings are based on the data in the China’s stock market, other global markets may be considered in the future research. Practical implications Evidence indicates that a rise in EPU produces a negative effect on stock returns at the time news hits a market; however, investors will be rewarded by a premium as prices rebound in the subsequent period for compensating the investment decision made at a high uncertainty period. Originality/value The excess stock returns are negatively related to the EPU innovations, regardless of whether EPU originates from a domestic source or external sources.