Risk-return tradeoff and serial correlation in the Chinese stock market: A bailout-driven crash feedback hypothesis

Abstract

This paper explores two puzzling phenomena about aggregate stock market behavior: the weak mean–variance (risk-return) relation and return autocorrelation. Existing literature typically analyzes these two phenomena in isolation, with few attempts to understand their coexistence. To bridge this gap, we integrate two key factors, market-wide bailout guarantees and feedback trading, within the context of the Chinese stock market. We develop joint pricing formulas to theoretically show that feedback traders’ speculation on bailouts can simultaneously produce these anomalies by tying them to features typical of market crashes. Our empirical analysis, based on Chinese market data from 1997 to 2020 and a market crash index, provides consistent support for these theoretical derivations. The results highlight the significant role of speculation driven by bailout expectations in influencing aggregate stock market dynamics. Accordingly, this also illuminates the necessity for further research on the extensive pricing implications of both government intervention and speculative trading.