Abstract
The goal of this study is to evaluate the importance of skewness in investor utility when predicting stock market return by financial ratio variable. We use the daily time series of four major stock market indices of Shanghai Stock Exchanges and Shenzhen Stock Exchanges. We find evidence of predictability of price-to-earnings ratio and price-to-book ratio on the market returns. Using the evidence of predictability, we find evidence that including skewness leads higher utility. The comparison among different ways to calculate the skewness indicate the calculation method mostly used in popular statistical software may lead to the highest utility.
Highlights
As the two stock markets in Mainland China, the Shanghai Stock Exchange (SSE) and the Shenzhen Stock Exchange (SZSE) began their operations in December 1990
The major focus in this study is to argue whether the third moment added to the mean-variance utility function may provide higher utility to the investors
Using the time series daily data of four major stock market indices of China stock markets (Shanghai Stock Exchanges and Shenzhen Stock Exchanges), we find evidence that the price-to-earnings ratio (PE) may provide a better predictive ability than the other financial ratio variable price-to-book ratio (PB)
Summary
As the two stock markets in Mainland China, the Shanghai Stock Exchange (SSE) and the Shenzhen Stock Exchange (SZSE) began their operations in December 1990. In the Shenzhen Stock Exchange there were 1870 companies listed, with a market value of 22.31 trillion yuan and annual cumulative trading volume of 77.6 trillion yuan by the end of 2016. Both Shanghai Stock Exchange and Shenzhen Stock Exchange were closed markets and only Chinese investors are allowed to trade at the early stage of operation. Some studies have found that this assumption of quadratic utility function is only appropriate for relatively low rates of return (Tobin, 1958 [13]; Pratt, 1964 [14]) It seems that including the third (skewness) moment is necessary when constructing the utility function. The conclusion and suggestion for future research are summarized in the last section, Section 6
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