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Financial risk, uncertainty and expected returns: evidence from Chinese

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Article  in  China Finance Review International · July 2019

DOI: 10.1108/CFRI-09-2018-0129

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Financial risk,
Financial risk, uncertainty and uncertainty
expected returns: evidence from and expected
returns
Chinese equity markets
Thomas C. Chiang
Department of Finance, LeBow College of Business,
Received 17 September 2018
Drexel University, Philadelphia, Pennsylvania, USA Revised 7 December 2018
4 January 2019
Accepted 4 April 2019
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.
Keywords Downside risk, Chinese stock market, Economic policy uncertainty
Paper type Research paper

1. Introduction
It is well recognized that sudden changes in economic policy uncertainty (EPU) will produce
harmful effects on macroeconomic activity and cause financial market instability (Bloom,
2009; Leduc and Liu, 2016). In the past decade, we have witnessed a series shocks, including
the world financial crisis in 2008–2009, the Eurozone debt crisis in 2012, the Chinese stock
market crash in 2015 and Trump’s announcement of tariff increases in 2018. All of these
events have jeopardized economic order, disrupted investment sentiment, and led to
investors’ financial losses.
For instance, the S&P 500 in the USA suddenly dropped 4.10 percent on February 5, 2018.
This decline led to a 2.51 percent plunge in the UK FTSE, and a drop of 2.96, 3.00 percent, and
2.68 percent in the German DAX, French CAC 40 and Italian FTSE MIB, respectively. The
retreat in the US markets caused damage in the Asian markets, as the Chinese Shanghai stock
index plunged by 3.38 percent, Hong Kong HIS felled by 5.02 percent, and Japanese’s Nikkei
index was down by 4.73 percent in the following day. This episode highlights a phenomenon
that uncertainty shocks have a contagious effect on global markets (Forbes, 2012).
Since risk implies future uncertainty or a deviation from expected earnings or expected
outcome (Economic Times, https://economictimes.indiatimes.com/definition/risk),
researchers of the mean–variance approach (Markowitz, 1952) then use variance of stock
China Finance Review
JEL Classification — G11, G12, G15 International
Thomas C. Chiang would like to thank the support from Marshall M. Austin fund, LeBow College of © Emerald Publishing Limited
2044-1398
Business, Drexel University. DOI 10.1108/CFRI-09-2018-0129
CFRI return or implied volatility (VIX) to measure the risk on stock investments (Whaley, 2009;
Chen and Chiang, 2016a). Typically, we observe that the stock return and volatility are
negatively correlated in the current period and positively correlated with the lagged
variance. The rationale behind this movement reveals that a rise in volatility creates fear
among some investors who tend to sell their stocks. This selloff causes stock prices to
decline further, inducing rational investors who expect prices to reverse in the future to
place new orders. Thus, in his intertemporal capital asset pricing model (ICAPM),
Merton (1973, 1980) postulates a positive risk-return relation in stock markets. The evidence
by French et al. (1987), Scruggs (1998), Bali and Peng (2006) and Chiang et al. (2015)
confirm that investments in higher risk assets are rewarded by higher returns, although
some studies, such as Campbell et al. (1997), Nelson (1991) and Glosten et al. (1993), cannot
find strong evidence to support this positive relation. Therefore, there is no agreement on
the risk-return relation.
A key issue faced by researchers is the lack of a concise way to measure risk, which
is often subject to the rationale of researchers who use a certain set of information as
justification (Ghysels et al., 2005). A common approach in empirical studies is that the risk is
typically measured by conditional variance developed with a GARCH-type process (Engle,
2009; Bollerslev, 2010). Despite its explanatory power in describing risk, the conditional
variance series has been observed to be too smooth to reflect the underlying uncertainty
(Chen et al., 2018). Even a GARCH-X model is considered in this investigation, predicting the
conditional variance is essentially based on the input of financial information (Bollerslev
et al., 1992), which excludes uncertainties such as political risk, policy innovations or social
news. It follows that to analyze the uncertainty shocks on stock returns, the information
should go beyond the financial risk scope to tackle the issue. To fill this gap, it is appropriate
to use an alternative and complementary index to measure policy uncertainty. The early
studies such as Cornell (1983), Mishkin (1982) and Lauterback (1989) simply rely on a
policy/state variable, such as an unexpected change in money supply or a change in interest
rate to serve as a measure of a monetary policy uncertainty that affects asset returns. This
approach, despite of its concise measure of monetary news, narrowly defines policy
uncertainty. A recent development of the indices of EPU by Baker et al. (2016) provides
broad coverage of news, which can reflect economic policy uncertainties from domestic and
global perspectives. Baker et al. (2016) show that an EPU index is considered a reliable and
accurate measure of national policy uncertainty. This finding has resulted in a resurgence of
interest in EPU as a way of analyzing economic activity and financial market performance.
Numerous studies show that uncertainty has a negative effect on stock market
performance. The literature can be divided into two categories. One pertains to the studies of
EPU on stock returns, the other focuses on the investigation of EPU on stock price volatility.
In the first category, Bansal et al. (2005) show that increased economic uncertainty leads to
lower asset prices. Ozoguz (2009) finds a significant and negative relationship between stock
prices and uncertainty. Pastor and Veronesi (2012) show higher uncertainty about the
government policy is tied to a stock price decline. Antonakakis et al. (2013), Brogaard and
Detzel (2015), Li (2017) and Chen et al. (2017) report that a correlation between EPU and
stock market returns is considerably negative. Using a Bayesian vector-autoregression
(BVAR) model, Leduc and Liu (2016) document that an increase in uncertainty raises
unemployment and lowers inflation, which suggests that the macroeconomic effects of
uncertainty operate partly through an aggregate-demand channel. This decline in aggregate
demand, in turn, leads to a slowdown in the economy, and hence worsens future cash flows.
Thus, a rise in uncertainty causes a decline in stock prices.
The second category of literature suggests that uncertainty causes higher stock market
volatility. For instance, Pastor and Veronesi (2012) provide an economic rationale to explain
how policy uncertainty influences stock market volatility (2015). Liu and Zhang (2015) show
that the inclusion of EPU helps to improve forecasting ability of existing volatility models; Financial risk,
they conclude that higher EPU leads to increases in stock volatility. By considering the uncertainty
cross-market influences, Tsai (2017) finds that EPU has predictive ability not only to explain and expected
local stock volatility but also to describe cross-market volatility. The significance of
cross-market spillovers is mainly due to the contagion effect or international trade returns
involvement among trading partners (Balli et al., 2017; Chen et al., 2018). In sum, empirical
studies (Klößner and Sekkel, 2014; Hammoudeh and Mcaleer, 2015) find evidence for the
existence of cross-country EPU innovation-spillovers.
Motivated by the above empirical evidence, this study presents an integrated model that
specifies (excess) stock returns as a function of both risk and uncertainty variables while at the
same time using changes in market sentiment and liquidity as control variables. Since most
studies are on the USA or other advanced markets (except Chen et al., 2017), this study focuses
on the Chinese stock markets based on several timely reasons[1]. First, China’s sustainable
growth over the past two decades has led to a massive accumulation of international reserves,
which has translated into a considerable supply of funds and created a high demand for
investments in equity market. Second, with the increasing liberalization of financial policy by
the government, China’s stocks have more “connects” with global financial markets (Borst,
2017); these connects, in turn, will likely increase Chinese stocks’ exposure to global risk[2].
Third, the influence of government policy on asset prices in China is well known (Chen and
Chiang, 2016b; Chen et al., 2017; Hu et al., 2018). As result, it is of interest to investigate the
impact of policy uncertainty on asset prices in the Chinese equity market. Thus, the empirical
results of this study can not only give investors a better understanding of the source of risk on
asset pricing but also add to policymakers’ knowledge regarding the impact of uncertainty on
market volatility, which can help to maintain financial market stability.
By applying China’s aggregate and ten sectoral stock market data, this study contributes
to the literature in the following ways. First, evidence supports the positive risk-return
tradeoff hypothesis when the risk is measured by the conditional standard deviation using
the asymmetric GARCH(1,1)-M procedure fitted for the month’s stock returns. Second, this
study finds a positive downside risk-return relation when the downside risk is derived from
the greatest loss of daily trading over the past 21 trading days. The evidence is in line with
the downside risk premium hypothesis proposed by Bali et al. (2009) and Chen et al. (2018).
Third, the excess stock returns are negatively related to the EPU innovations, regardless of
whether EPU originates from a domestic source or external sources: the US market or the
global market (Chiang, 2019a). Fourth, although the uncertainty innovations reveal negative
signs, the evidence implies that stock returns are positively correlated with the longer
lagged EPU; evidence suggests that a rise in EPU produces a negative effect on stock
returns at the time news hits market; however, investors will be rewarded by a premium as
prices rebound in the subsequent period, compensating them for high uncertainty. This
finding supports both local and global uncertainty premium hypotheses. This has not been
recognized in the current literature, such as Li (2017) and Chen et al. (2017). Fifth, this study
provides evidence to validate that China’s stock prices are sensitive to both financial and
economic uncertainties; this is the case whether the tests apply to the aggregate or sectoral
data. The evidence suggests that conventional studies (Bali et al., 2009; Bali and Cakici,
2010; Lundblad, 2007) of risk-return relation that fail to incorporate the EPU innovation in
the test equation are likely to generate biased estimators.
The remainder of this paper is organized as follows. Section 2 presents a model that
summarizes economic rationale featuring the (T)ARCH-M process as a way to examine
stock return behavior. Four different testable hypotheses related to risk and uncertainty
that are present in stock returns are set up. Section 3 describes the data and a summary of
statistics. Section 4 presents the empirical evidence for both aggregate and sectoral stock
returns. Section 5 conducts robustness tests and Section 6 concludes the findings.
CFRI 2. Economics of risk and return
2.1 Economic rationale
Recent empirical analysis of stock returns uses two different measures of risk. The
intertemporal CAPM (ICAPM) model (Merton, 1973) posits that an increase in stock returns
is associated with higher expected market risk. French et al. (1987), Scruggs (1998),
Bollerslev et al. (1992), Engle (2009) provide substantial support to justify of the use of a
conditional variance as a risk variable. However, this measure in fact picks up volatilities
that are predictable. Moreover, it appears to show too much smoothing and fails to reflect
the big change in stock prices. Therefore, the second measure of risk takes on an extreme
downside price movement to cope with investors who are more risk averse and place a high
priority on safety. Bali et al. (2009) find supporting evidence for using Value-at-Risk (VaR) in
predicting stock returns after controlling for some economic factors. Bali et al. (2009) confirm
a positive intertemporal relation between expected stock returns and the VaR. Additionally,
in their investigation of G7 markets, Chen and Chiang (2016a) document that a positive
intertemporal downside risk-return relation presents in an ordinary volatility regime.
However, as uncertainty rises, the sign of the
risk-return
 relation turns to negative. The
above empirical studies indicate that both E t
1 s2t and Et−1[VaRt] may constitute different
sets of information that help investors to make decisions on their investments. Yet, both
measures are confined to the risk in equity market and fail to capture the unpredictable
components of policy uncertainty beyond expectations on financial market. A recent study
by Chen et al. (2017) suggests that EPU has significant informational content that can be
helpful in predicting future stock returns. For this reason, it is appealing to include EPU
innovation to complementarily measure uncertainties beyond conditional variance and
downside risk of the stock return.

2.2 The model

Following the previous discussions, stock return is specified as a linear function of financial
risk and uncertainty variables as follows:

Rm;t ¼ b0 þ b1 s^ t þ b2 V aRt þ b3 V aRt
1 þ b4 DEPU CN US

t
1 þ b5 DEPU t
1 þ b6 DX s;t
1 þ et ; (1)

where β1 W 0, β2 o 0, β3 W 0, β4 o 0, β5 o 0, β6 W 0.

X
p X
q
s2t ¼ oþ ai e2t
i þ bi s2t
i þgDe2t
1 ; (2)
i¼1 i¼1
Pp Pq 
where ωW0, ai ⩾ 0 bi ⩾ 0 and i¼1 ai þ o 1.
i¼1 bi
 2 
et jOt
1 HGED 0; st
1 ; u et : (3)

Equation (1) is a mean equation and Rm,t is the market stock return. s^ t and VaRt are
financial risk variables. The s^ t is the conditional standard deviation (French et al., 1987),
β1 W0 indicates that a higher stock return is expected if there is a higher expected volatility.
The VaRt is the extreme downside price change at time t, the coefficient β2 o0 means that
stock return declines as downside risk rises due to investors’ fear of a further fall in prices;
β3 W0 indicates that a higher return is anticipated in the future period if investors are
willing to assume the risk of buying stocks during the time of a big price drop.
The EPUt is the natural log of EPU reported by Baker et al. (2016), which summarizes
news associated with economics, policy and uncertainties. Thus, the coefficient β4 o0
indicates that as uncertainty innovation rises, investors tend to selloff stocks, pushing down
stock prices. Likewise, given an integrated world capital market, a rise of EPU innovation in
the US market may produce a similar effect as the EPU innovation in Chinese market, this Financial risk,
phenomenon leads to β5 o 0. uncertainty
Following the literature (Chen and Chiang, 2016a; Chiang and Zhang, 2018), it is and expected
appropriate to add control variables, Xs, such as a change in market sentiment Δ(SENTt)[3],
to capture the influence investment sentiment and the role of liquidity on stock returns. As returns
noted by Baker and Wurgler (2007), a rise in the sentiment index signifies a brightening
prospect for business investment, which leads to higher expectations on stock returns.
Fama and French (2015) find this variable to be a significant factor in explaining stock
returns and motivated this study to include the growth in investment sentiment in the
examination of stock returns (Chen and Chiang, 2016b; Chiang and Zhang, 2018).
The literature also suggests that liquidity consistently plays a meaningful role in explaining
the stock return premium. Amihud (2002) and Pastor and Stambaugh (2003) find evidence
that the correlation between realized excess returns and a change in illiquidity is negative.
This stems from the fact that positive shocks of illiquidity usually reflect the poorer than
expected performance that firms are experiencing; to attract investors, firms’ prevailing
stock prices have to fall. Thus, the coefficient of ΔLIQt is expected to be positive, β6 W 0.
Equation (2) describes the dynamic process of conditional volatility of stock returns in
the form of Threshold-GARCH(1,1)-M model (Glosten et al., 1993; Chiang and Doong,
2001). In this equation, the conditional variance, s2t , is generated by the past shock squared
and the lagged conditional variance plus an asymmetric effect due to negative news. The
variance equation in Equation (2) captures not only the volatility clustering phenomenon,
but also the asymmetrical impact of news on the conditional variance. The survey by
Bollerslev et al. (1992) suggests that the GARH(1,1) should be sufficient for modeling the
conditional variance[4].
Equation (3) is modeled as a generalized error distribution (GED) as proposed by Nelson
(1991). This distribution is appealing when errors are not normally distributed, either in case
of heavy tails or highly skewed tails[5]. Gao et al. (2012) report that this distribution is the
best model to describe stock market volatility in China’s stock return series.

2.3 Testable hypotheses

Equation (1) provides a dynamic regression framework, which is pertinent in testing the
risk/uncertainty and return relations. To identify the unique source of risk/uncertainty, this
section outlines each hypothesis as follows.
Conditional risk-return hypothesis. This is the conventional risk premium hypothesis that
posits a positive risk-return relation postulated by Merton (1973). It predicts that as market
risk is perceived to be higher, a greater risk premium is required to induce investors to
purchase stocks (French et al., 1987). The risk under this paradigm is projected by the past
variance and shock squares as implied in a TARCH(1,1)-M process (Bollerslev et al., 1992;
Glosten et al., 1993). Thus, if estimated β1 W0, then the risk-return tradeoff is confirmed,
supporting the existence of investors’ risk aversion.
Downside risk premium hypothesis. This hypothesis reveals that investors are concerned
about a big loss on their investments (Bali et al., 2009; Chen and Chiang, 2016a; Chen et al.,
2018). This safety-first attitude becomes more apparent when a market experiences a severe
downside movement. It follows that the estimated slope of the lagged downside risk
provides empirical justification of the downside risk. Thus, if β3 W0, then the evidence
confirms to the downside risk premium hypothesis.
Local (Chinese) economic policy uncertainty premium hypothesis. Motivated by the
literature that a rise in EPU signifies a potential deterioration of economic activities that in
turn jeopardizes future cash flows (Bloom, 2009; Leduc and Liu, 2016), it is anticipated
that the expected stock returns covariate negatively with the EPU innovation (Li, 2017;
CFRI Chen et al., 2017). That is, β4 o0, where DEPU CN t
1 denotes China’s EPU innovation, which is
measured by the log-difference of China’s EPU index. This transformation is appropriate,
since the unit-root test suggests that DEPU CN t turns to a stationary process after taking
the first difference[6]; it also helps to alleviate the impact of serial correlations. More
succinctly, if the estimated β4 indeed turns out to be negative, it is consistent with the notion
that rational traders will be rewarded by an uncertainty premium, since

b4 DEPU CN CN CN
t
1 ¼
b4 EPU t
1 þb4 EPU t
2 . This suggests that rational traders who buy
shares at time t-1 when uncertainty is high will see stock returns turn to positive as
the prices bounce back in the subsequent period. Thus, β4 W0 for EPU CN t
2 implies an
uncertainty premium rewards to rational traders.
Global economic policy uncertainty premium hypothesis. This hypothesis is tied closely to
the global financial contagious hypothesis (Chiang et al., 2007; Forbes, 2012; Klößner and
Sekkel, 2014; Chen et al., 2018). It has been argued that the news of an increase in uncertainty
over the global market is soon learned by investors in Chinese market via mass media,
digital devices, the trade connections or financial institution linkage channel, inducing
investors to reassess their portfolio positions. It follows that expected stock returns
covariate negatively with global EPU innovation. That is, β5 o 0, where DEPU US t
1 is the
US (or global) EPU innovation. As we argued earlier, this hypothesis implies that rational
traders will receive an uncertainty premium due to their decision to place order at the time of
high uncertainty in global market. Empirically, we anticipate that the coefficient of EPU U S
t
2
to be positive.

3. Data and summary of statistics

3.1 Data description
The data in this study cover the sample period from January 1997 through February 2017,
which lines up with the starting date of sectoral data except for the oil & gas sector. Both
daily and monthly data were downloaded from Datastream. The monthly data were closed
prices at the end of the month[7]. The aggregate data consist of the US S&P 500 stock index
and the Shanghai Stock Exchange-A (SHSE-A) share index for China’s market. To check
robustness, China’s aggregate stock data from International Financial Statistics (IFS) and
other index measures are also employed. In empirical analysis, the SHSE-A share index will
be used to generate the conditional volatility and downside risk, since the sectoral data are
available from the industries in A-share by the Datastream. Economic variables in
estimation are transformed by taking the natural log or log-difference, including changes in
log-trading turnover volume of stocks (Datar et al., 1998; Chan et al., 2002), as a way of
measuring the change in liquidity (ΔLIQt) and the change in investment climate for change
in investment sentiments (ΔSENTt)[8].
To be consistent with the asset pricing model, both stock returns and excess stock
returns are used; the latter is arrived at by subtracting on one-month deposit rate from
monthly stock returns. The stock return is measured by the natural log-difference of the
stock price index times 100. The sectoral data on stock indices are: Basic Materials (BMAT),
Banks, Consumer Services (CNSS), Financial (FINA), Financial Services (FINS), Industrial
Goods and Service (IDGS), industrials (INDU), Oil and Gas (OILG), Real Estates (REST),
Travel and Leisure (TVLE) and Utilities (UTIL).
The EPU measures considered in this study are: the US EPU ðEPU U S
t Þ, China EPU
CN G
ðEPU t Þ, and Global EPU ðEPU t Þ. The data are obtained from Baker et al. (2016).
The EPU U t
S
is constructed from three types of underlying components: newspaper
coverage of policy-related economic uncertainty based on ten large newspapers, such as
USA Today, The Chicago Tribune, The Washington Post, etc.; the number of federal tax code
provisions set to expire in future years; disagreement among economic forecasters as a
proxy for uncertainty. Specifically, the US EPU index is based on searches of the digital Financial risk,
archives of each paper to obtain a monthly count of articles that contain the following trio of uncertainty
terms: “uncertainty” or “uncertain”; “economic” or “economy”; and one or more of terms of and expected
“deficit,” “the Fed,” or “White House,” and “uncertainties” or its variants. Baker et al. (2016)
find this uncertainty index is reliable, unbiased, and consistent since the uncertainty index returns
is highly correlated with market implied volatility, VIX (Whaley, 2009) is closely related to
other text-based measures of policy uncertainty, such as the Fed’s Beige Books mention of
policy uncertainty.
The EPU index for China ðEPU CN t Þ (Baker et al., 2016, www.policyuncertainty.com) is
constructed from a scaled frequency count of articles about policy-related economic
uncertainty in the South China Morning Post (SCMP). Testing by the human readings
showed 492 of the 500 sample articles pertain to economic uncertainty for China. Further
testing the policy-related economic uncertainty count produced by automated search
methods exhibits a correlation of 0.82 with the true count (human reading) in quarterly time-
series data. Building on Baker et al. (2016), Davis (2016) constructs a monthly index of
Global Economic Policy Uncertainty ðEPU Gt Þ from January 1997. The EPU Gt Index is a
GDP-weighted average of national EPU indices for 16 countries that account for two-thirds
of global output. Each national EPU index reflects the relative frequency of own-country
newspaper articles that contain a trio of terms pertaining to the economy, uncertainty and
policy-related matters. The index rises sharply in reaction to the Asian Financial Crisis, the
9/11 terrorist attacks, the disturbances in Chinese economy in the second half of 2015, the
Global financial crisis in 2008, and the announcement of Brexit in June 2016. As a result,
Global Economic Policy Uncertainty Index provides a wide range of other EPU indices
available at www.PolicyUncertainty.com that help to measure the uncertainties among the
global economies. Moreover, for conducting the robustness test, the US fear index is
measured by the STLFSI (St Louis Fed Stress Index).

3.2 Summary of statistics

To obtain an overview of the variables under study, Table I reports summary statistics at
the aggregate level and 10 sectoral stock returns in Chinese stock markets. The statistics in
Panel A show the monthly average returns range from 0.09 (Industrials) to 0.34 percent
(Travel). The measure of return dispersion is indicated by the standard deviations (the
unconditional value), which range from 3.68 (Utilities) ~ 5.33 (Financial service). It should
be noted that the Jarque–Bera ( JB) statistics for testing the normality of the return series are
found to be highly significant, rejecting the normal distribution hypothesis. The JB statistics
are consistent with those reported by Gao et al. (2012) and support the decision to use the
GED distribution in this study.
Figure 1 presents the time-series plots of different indices for measuring aggregate stock
returns. Obviously, these series share higher degree of comovements and turning points,
reflecting their movements are subject to some common factors. It is also clear that the
markets are rather volatile as demonstrated by a bull market in 2007 that turned to a bear
regime after October of 2017 until bottoming out in October 2008 when the market had
plunged 66.71 percent within one year.
Panel B of Table I reports summary statistics of risk and uncertainties. The statistics
indicate that the China EPU is greater than that of the US and global markets regardless of
whether the measures are based on mean value, the standard deviation or maximum–
minimum spread. However, the evidence in Table II indicates that the global EPU (GEPU) is
highly correlated with EPU_CN (0.7598) and EPU_US (0.7375). Obviously, the STLFSI has
relatively lower correlation with other risk measures. Similarly, China’s VaR does not
correlated with other types of risk or uncertainties. The time-series plotted in Figure 2
provides a similar observation, where the STLFSI and EPU_CN were deviating from other
 CFRI

Table I.

ten sectors
for market and
of stock returns
Summary statistics
Panel A: aggregate and sectoral stock returns: January 1997– February 2017
SHSE-A SHSE- BASIC_M CONS_SVS FINANCIAL FIN_SVS INDS_G_SVS INDUSTRIALS OIL&GAS REAL_EST TRAVEL UTILITIES
C
Mean 0.18 0.25 0.08 0.28 0.20 0.19 0.20 0.09 0.13 0.12 0.34 0.21
Median 0.33 0.33 0.26 0.51 −0.01 0.12 0.24 −0.05 −0.06 −0.03 0.26 −0.03
Maximum 12.71 12.08 12.16 13.17 17.19 19.25 16.05 20.25 14.20 17.10 13.32 14.77
Minimum −12.27 −12.20 −17.60 −14.70 −12.95 −17.75 −14.79 −13.64 −11.94 −13.76 −14.14 −12.90
SD 3.53 3.51 4.19 4.21 4.21 5.33 4.05 4.38 3.88 4.48 4.38 3.68
Skewness −0.11 −0.30 −0.39 −0.10 0.82 0.30 0.14 0.46 0.23 0.24 −0.36 0.30
Kurtosis 4.63 4.62 4.86 4.35 6.01 4.77 5.45 5.69 4.91 4.33 4.42 5.16
Jarque−Bera 27.28 29.85 41.27 18.91 118.72 35.20 61.35 81.62 36.42 20.06 25.58 50.79
Observations 242 242 242 242 242 242 242 242 225 242 242 242
Panel B: risk factors at the aggregate level
GARCH_CN VaR EPU_CN EPU_US GEPU STLFSI
Mean 1.29 1.33 1.32 1.09 1.07 −0.10
Median 0.96 1.08 1.02 0.99 0.98 −0.35
Maximum 4.68 4.11 6.95 2.45 2.83 4.82
Minimum 0.55 0.35 0.09 0.57 0.50 −1.64
SD 0.75 0.82 1.03 0.36 0.43 1.05
Skewness 1.52 1.46 2.36 0.92 1.44 1.21
Kurtosis 5.15 4.68 10.51 3.22 5.70 5.99
Jarque–Bera 140.40 114.39 793.55 34.65 157.25 149.54
Observations 242 242 242 242 242 242
Notes: Panel A: stock returns are the monthly price change based on the end of the month from SHSE-A from Datastream. SHSE-C is the China SHSE composite index
from IFS. Panel B: the EPU_CN, EPU_US, GEPU were the respective original values multiplied by 10−2. GARCH_CN is original value times 10−1. The VaR is the
minimum value of the daily stock returns in the past 21 days multiplied by −1
 800 Financial risk,
700 uncertainty
600 and expected
500 returns
400

300

200
Figure 1.
100
Plots of stock indices
0 for Shanghai
1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 A-shares, Shanghai
Composite Index and
SHSE-A SHSE-C other measures
A-TMT A-RESO

Correlation
t-Statistic GARCH_CN VaR EPU_CN EPU_US GEPU STLFSI

GARCH_CN 1
–
VaR 0.5396 1
9.9298 –
EPU_CN −0.1363 −0.0071 1
−2.1309 −0.1101 –
EPU_US −0.1893 −0.0285 0.4169 1
−2.9860 −0.4425 7.1065 –
GEPU −0.2173 −0.0624 0.7598 0.7375 1
−3.4493 −0.9689 18.1068 16.9181 –
STLFSI 0.3033 0.2447 −0.1849 −0.0031 −0.1399 1
4.9307 3.9097 −2.9145 −0.0474 −2.1885 –
Notes: GARCH_CN is the conditional variance from a GARCH(1,1) process via regressing China’s stock Table II.
returns on a constant term. The value is scaled by times 10−1. VaR is measured by the min of 21 daily stock Correlation matrix of
returns times (−1). EPU_CN, EPU_US, and GEPU are the economic policy uncertainty for China, USA and risk factors ( January
global indices time 10−2, respectively. The STLFSI is the St Louis Fed stress index obtained from the USA 1997–February 2017)

–2 Figure 2.
1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 Time-series plots of
GARCH, VaR,
GARCH_CN VaR_CN EPU_CN EPU_CN, EPU_US,
GEPU and STLFSI
EPU_US GEPU STLFSI
CFRI series, especially in the post 2009 period. The chart also indicates that GARCH_CN is much
smoother as compared with sharply volatile values of the VaR. From this perspective, the
financial risk between conditional volatility and downside risk may have different
information content that influences stock returns despite the correlation exists.

4. Estimation results
4.1 Aggregate market
Panel A of Table III reports the estimates with various model specifications for China’s
aggregate stock market equations. To deal with the heteroscedasticity problem, the
GED-TARCH(1,1)-M procedure is used. The estimation in Model 1 begins with a two-factor
specification that relates the stock returns to conditional volatility and downside risk.
Model 2 includes the control variables, ΔSENTt−1 and ΔLIQt−1. In Model 3, DEPU CN t
1 is
added to the test equation. This specification will help to observe the incremental efficiency
of the China’s EPU innovation on the stock return. Then in Model 4, the DEPU U S
t
1 is
considered as an incremental variable. Note that the inclusion of the EPU innovations in the
test equation is appealing, since conditional volatility is a predictable component, which has
erroneously been attributable to uncertainty (Bahloul et al., 2018). Thus, it is crucial to
distinguish between uncertainty and the conditional volatility[9]. Since Models 1–3 are
nested in Model 4, the discussion is concentrated on Model 4.
Several empirical findings deserve our attention. First, the GED-TARCH(1, 1)-M model is
appropriate, and it is evident that all the parameters of TARCH(1, 1) elements are significant
and satisfy the parameter restrictions. The results suggest that stock return volatilities are
characterized by a heteroscedastic process. The asymmetric coefficient is negative and
statistically significant, confirming the asymmetric impact of bad news vs good news.
Second, the coefficient of conditional volatility, s^ t , predicted by TARCH(1, 1)-M is
positively associated with the stock return, and the t-statistics are large enough to reject the
null. A positively significant coefficient of s^ t supports the risk-return tradeoff hypothesis.
Third, the evidence shows that the contemporaneous term of VaR is negative,
while the intertemporal downside risk term of VaR is positive, and both coefficients are
significant at the 5 percent level. The negative sign of VaRt is consistent with the
behavior of noise traders who follow the current financial guru/institutions in the market
by selling off their stock as stock prices plunge (Sentana and Wadhwani, 1992),
which causes a dramatic decline in stock returns. This herding behavior of investors who
suppress their private information in making investments decision could cause stock
prices to deviate from their market fundamentals (De Long et al., 1990), resulting in
market inefficiency. Unlike noise traders, contrarian traders would consider the
placement new orders during a time of severely declining prices, since profitable
trading is anticipated should price reversals occur in the near future (De Bondt and
Thaler, 1985; Sentana and Wadhwani, 1992). The presence of a positive sign of VaRt-1
reflects the price reversal behavior in the following month, as these investors are
rewarded for bearing risk. Therefore, the testing result supports the downside risk
premium hypothesis.
Fourth, included in Model 4 of Table III are the control variables: the change of the
investment sentiment (Baker and Wurgler, 2007) and change in liquidity (Chiang and
Zheng, 2015). The estimated result indicates that a change toward more optimistic
investment sentiment helps to predict a higher stock return as shown by a positive sign of
ΔSENTt−1. This result is consistent with the finding by Baker and Wurgler (2007) in the US
data and those reported by Chiang and Zhang (2018) in China’s data, although the
components of measuring the sentiment may be somewhat different. This evidence supports
the notion that indicators signifying an optimistic investment climate help to predict higher
stock returns.
 S 2
Model C s^ t VaRt VaRt−1 ΔSENTt−1 ΔLIQt−1 DEPU CN
t
1 DEPU U
t
1 ω e2t
1 gDe2t
1 s2t
1 Q(12) w21 w22 R

Panel A
1 −3.080 1.359 −2.297 0.114 2.420 0.271 −0.195 0.763 0.17
−1.74 3.07 −29.72 2.07 2.86 2.44 −2.26 24.23
2 −1.953 1.184 −2.277 0.187 61.810 1.853 1.291 0.337 −0.307 0.785 12.33 384.1 0.20
−2.48 5.09 −24.90 2.64 7.95 16.02 2.92 3.38 −3.20 37.22 (0.42) (0.00)
3 −2.227 1.081 −2. 207 0.338 77.064 1.494 −0.004 1.951 0.276 −0.312 0.777 12.19 9.01 0.22
−1.54 2.84 −37.50 3.36 7.49 8.13 −3.14 2.66 2.13 −1.90 24.16 (0.43) (0.00)
4 −1.207 0.830 −2.082 0.306 96.092 1.607 −0.002 −0.010 1.148 0.458 −0.389 0.768 12.38 17.02 21.03 0.20
−2.06 4.50 −29.57 5.44 18.49 12.23 −2.10 −4.13 2.26 3.04 −2.84 42.18 (0.42) (0.00) (0.00)
Panel B
4.1 −2.947 1.101 −1.888 0.482 34.020 1.922 −0.002 −0.010 1.342 0.175 −0.167 0.854 12.34 5.38 7.09 0.11
−2.24 3.27 −17.46 5.69 3.33 15.64 −1.74 −2.32 2.33 2.23 −2.02 40.61 (0.42) (0.02) (0.03)
4.2 −0.729 1.283 −2.423 −0.392 93.056 0.688 −0.005 −0.010 0.916 0.389 −0.389 0.785 10.69 12.77 67.72 0.34
−1.03 5.25 −26.34 −3.85 7.56 4.20 −7.15 −3.57 2.14 2.88 −2.73 44.51 (0.56) (0.00) (0.00)
Notes: The dependent variable from Models (1)–(4) is the monthly stock return, Rt. The independent variable s^ it is the conditional volatility measured deviation from the
monthly GED-GARCH(1, 1)-M process; the VaRt is the downside risk defined as the minimum of daily stock returns in the past 21 days (Bali et al., 2009). The original
VaRt s are multiplied by −1 before running regressions. ΔSENTt−1 is change of sentiment, ΔLIQt−1 is change of trading turnover. DEPU CN t
1 measures the economic
S 2 2
policy uncertainty innovation in China; DEPU U t
1 denotes the economic policy uncertainty innovation in the US market. The o; et
1 and st
1 are constant, lagged shock
squared and lagged conditional variance of market returns D is a dummy variable, which is set to unity as a negative shock occurs and zero otherwise. Q(12) is the
Ljund–Box Q statistics for testing the autocorrelations of the model residuals up to 12 orders. The numbers in the bracket are p-values. w21 in Model 3 tests the incremental
2 US 2 CN
efficiency of DEPU CN t
1 relative to Model 2. w1 in Model 4 tests the incremental efficiency of DEPU t
1 w2 in Model 4 tests joint significance of DEPU t
1 ¼
S
DEPU U t
1 ¼ 0. The first row reports the estimated coefficients, the second row contains the estimated t-statistics. Equations (4.1) and (4.2) are the subsample estimations
using 2008/2010 crisis as a dividing line. Model 4.1 is based on the sample before crisis, while Model 4.2 is estimated based on the post-crisis period
uncertainty
and expected
returns
Financial risk,

uncertainty with a
Estimates of

sentiment, fear,

GED-TGARCH-M
returns on conditional

model
economic policy
risk, investment
aggregate stock
Table III.

volatility, downside
CFRI One of the key factors that facilitate business operation in daily transactions is liquidity,
which is measured by the turnover rate of the trading volume. The inclusion of ΔLIQt−1 in
the test equation reflects the impact of a change in liquidity on stock returns. The result
indicates that the estimated coefficient of ΔLIQt−1 is positive and significant. This finding is
consistent with the results in the US market (Elyasiani et al., 2000; Pastor and Stambaugh,
2003), the G7 markets (Chiang and Zheng, 2015) and the evidence in Chinese market (Chiang
and Zhang, 2018).
Fifth, despite of their significance in explaining stock returns, the above variables are
confined to aspects of financial information. The matter of fact is that stock returns are often
sensitive to prevailing news involving political risk, policy innovations, changes in legislation,
terrorist attacks, war, etc. Thus, inclusion of broad news in measuring uncertainty is called
for. The measures of EPU in China ðDEPU CN US
t
1 Þ and the USA ðDEPU t
1 Þ are considered as
independent arguments, respectively, and are included in the test equation. The results in
Table III show that both coefficients are negative and significant at the 5 percent level or
better. The negative coefficient suggests that a rise in uncertainty will predict a decline in
China’s stock returns. This occurs when uncertainty originates not only from the local market
but also from the US market; the latter effect may be attributable to market integration or
contagious effect (Bekaert and Harvey, 1995; Chiang et al., 2007; Tsai, 2017; Chen et al., 2018).
The evidence supports the existence of cross-country EPU spillovers (Klößner and Sekkel,
2014) and indicates that the impact of uncertainty from the US market is even more profound,
a reflection of the powerful position the US has in the world financial market (Rapach et al.,
2013). The evidence thus supports the hypothesis that equity premium flows to rational
investors who place order at a time of a greater uncertainty.
To examine the parametric stability, the Model 4 is re-estimated by using October 2008,
the climax of world financial crisis as a dividing line. The Model 4.1 is estimated by using
the sample before the crisis, while the Model 4.2 is based on the sample of the post-crisis
period. The estimates derived are comparable, the coefficients of the DEPU U S
t
1 at different
sample present no difference. However, the coefficient of lagged VaR for the post-crisis
period continues to be negative, this short-run crisis effect turns to positive as shown in the
full sample estimation in Model 4.
In addition to the t-statistics, Table III also reports the Lagrange Multiplier (LM) tests
using χ2 distribution to justify the contribution of the incremental variable. The w21 reported
in Model 3 tests the incremental efficiency of DEPU CN t
1 relative to Model 2. w1 in Model 4,
2

including 4.1 and 4.2, tests the incremental efficiency of DEPU U S

;
t
1 2 w2
in Models 4–4.2 test
joint significance of DEPU CN US
t
1 ¼ DEPU t
1 ¼ 0. The testing results suggest that the nulls
are rejected at the 5 percent level, indicating that the DEPU CN US
t
1 and DEPU t
1 individually
and/or jointly are significant. The evidence thus consistently concludes that the EPU is an
important factor in explaining the stock return, and the exclusion of the EPU would
generate biased estimators.

4.2 Evidence from sectoral markets

Estimates of the aggregate market provide an overall picture on the behavior of stock
returns. Nonetheless, it covers very little information on sectoral portfolio performance. This
section offers empirical evidence on ten sectoral analysis in Chinese equity markets.
Following the same strategy, the sectoral stock return equation is given as follows:
Ri;t ¼ b0 þb1 s^ it þb2 V aRt þb3 V aRt
1 þb4 DSEN T t
1 þb5 DLI Qt
1
U S=G
þb6 DEPU CN
t
1 þb7 DEPU t
1 þeit ; (4)

s2it ¼ oi þ a1 e2i;t
1 þg 1 I

t
1 ei;t
1 þb1 sit
1 :
2 2
(5)
All the variables are defined as previously stated. However, the subscript i is an index for Financial risk,
sectors, where i ¼ 1, 2,…,10. Equation (4) states that stock return in sector i depends on its uncertainty
own conditional volatility, the market downside risk at time t and t–1, the control variables and expected
and economic policy uncertainties. The control variables are ΔSENTt−1 and ΔLIQt−1 and
the EPU innovations include both the China and US (or Global) markets. The error returns
distribution is comparable to Equation (3) in assuming a GED for each sector; the
conditional standard deviation, s^ it , is generated from the GED-TARCH(1, 1)-M process as
described in Equation (5).
The estimations of the sectoral models using stock return as dependent variable are
reported in Tables IV–VI. Table IV reports the results corresponding to Model 2 in
aggregate market estimations by restricting to the arguments in standard financial
variables, s^ it , VaRt, VaRt−1, ΔSENTt−1, and ΔLIQt−1, while Table V reports the results,
adding the uncertainty innovation from Chinese source, that is, DEPU CN t
1 ; Table VI contains
an incremental variable of the US uncertainty innovation, that is, the DEPU U S
t
1 .
Since Table VI, which is equivalent to the Model 4 in aggregate estimation in Table III, is
more general, the interpretation will focus on Table VI.
The statistical results in Table VI are largely comparable with those of the aggregate
market model. The estimated values in the first row are the estimated coefficients, the
second row are the estimated t-statistics. Several points are worth noting. First, sectoral risk
of conditional volatility is consistently priced in the sectoral stock returns. This is evident by
positive signs for all coefficients of s^ it , which are each statistically significant. This result
supports the risk-return tradeoff in each sector under investigation.
Second, consistent with the aggregate market, coefficients of VaRt for all sectors produce
negative signs and are significant at the 1 percent level, suggesting the monthly returns are
sensitive to downside risk. An increase in downside risk prompts a selloff of stocks that
causes a decline in sectoral stock returns. Nevertheless, the sign of VaRt−1 is positive,

2
Sector C s^ it VaRt VaRt−1 ΔSENTt−1 ΔLIQt−1 ω e2t
1 gDe2t
1 s2t
1 R

Basic_M −0.585 0.519 −2.361 0.688 6.831 1.969 1.863 0.271 −0.090 0.735 0.12
−0.62 2.09 −12.82 4.44 0.32 9.28 1.54 1.86 −0.67 7.84
Cons_Svs −7.946 2.389 −2.413 0.456 83.190 1.585 7.542 0.224 −0.180 0.502 0.18
−2.51 3.28 −15.86 2.81 5.62 6.37 3.88 2.60 −2.95 6.73
Financial −3.176 0.706 −2.761 0.702 −50.518 1.679 6.789 0.384 −0.944 0.831 0.12
−4.88 20.36 −35.37 11.47 −6.38 13.73 3.69 5.58 −5.11 63.86
Finan_Svs −4.895 1.213 −2.435 0.396 154.932 0.930 3.725 0.140 −0.203 0.847 0.08
−3.78 5.20 −10.65 2.13 7.53 3.60 11.42 2.84 −2.75 33.97
Ind.Gds-Svs −0.986 0.865 −2.305 0.277 56.613 0.823 2.237 0.444 −0.318 0.621 0.15
−1.05 2.85 −15.42 2.19 3.32 3.53 2.83 2.34 −1.81 10.76
Industrials −1.640 0.496 −1.788 0.906 15.122 1.817 6.608 0.547 −0.262 0.566 0.09
−1.43 2.24 −12.65 15.10 1.23 13.23 2.04 1.85 −1.35 5.73
Oil and gas −0.063 0.642 −2.316 0.421 58.638 2.034 1.583 0.265 −0.163 0.723 0.15
−0.08 2.50 −11.22 2.04 2.79 6.19 2.79 2.02 −1.18 10.29
Real estate −10.086 2.739 −2.602 0.655 100.817 0.892 4.052 0.100 −0.049 0.739 0.11
−4.11 4.79 −12.87 4.29 4.09 2.77 4.45 3.13 −1.74 30.89
Travel −1.778 0.979 −2.955 1.061 67.035 1.710 2.015 0.200 −0.069 0.766 0.17
−1.11 2.71 −13.68 6.02 2.64 4.47 1.59 2.09 −0.83 11.68
Utilities −1.212 0.897 −1.906 0.240 34.417 1.291 0.924 0.152 −0.143 0.840 0.11
Table IV.
−1.41 3.26 −10.81 1.72 1.75 5.15 2.40 2.48 −1.79 22.84
Estimates of sectoral
Notes: The dependent variable is monthly stock return Rit; the s^ it is the conditional volatility from the stock returns on
threshold GED-GARCH (1,1)-M model. VaRt is the downside risk (Bali et al., 2009). The original VaRts are conditional volatility,
multiplied by −1 before running regressions. ΔSENTt−1 is change of sentiment, ΔLIQt−1 is change of trading downside risk,
turnover. o; e2t
1 and s2t
1 are constant, lagged shock squared and lagged conditional variance of market 2
sentiment and
returns. D is a dummy variable, which is set to unity as a negative shock occurs and zero otherwise. The R liquidity with a GED-
2
is the adjusted R . The first row is the estimated coefficient, the second row is the estimated t-statistics TGARCH-M model
 model
CFRI

Table V.

downside risk,
stock returns on

innovation with a
GED-TGARCH-M
policy uncertainty
sentiment, liquidity
and China economic
Estimates of sectoral

conditional volatility,
2
Sector C s^ it VaRt VaRt−1 ΔSENTt−1 ΔLIQt−1 DEPU CN
t
1 ω e2t
1 gDe2t
1 s2t
1 w21 R

Basic_M −0.651 0.726 −2.319 0.442 17.218 1.724 −0.008 1.805 0.259 −0.189 0.750 10.55 0.16
−0.59 2.33 −10.06 1.99 0.66 5.92 −3.25 1.82 1.95 −1.49 9.76 0.00
Cons_Svs −10.612 2.106 −2.078 0.218 92.712 1.733 −0.004 9.177 0.173 0.016 0.709 18.49 0.16
−9.73 6.43 −27.91 2.39 13.91 19.28 −4.30 3.32 3.14 0.56 32.79 0.00
Financial −0.507 0.454 −1.699 0.612 86.709 2.585 −0.002 5.423 1.099 −0.752 0.513 2.860 0.17
−1.53 11.60 −15.75 5.30 7.21 14.06 −1.69 2.79 3.98 −2.67 10.70 0.09
Finan_Svs −4.119 1.198 −2.426 0.359 136.621 1.152 −0.008 1.995 0.099 −0.161 0.898 15.35 0.10
−2.25 3.46 −14.81 1.95 4.99 3.19 −3.92 2.35 2.53 −2.51 31.72 0.00
Ind.Gds-Svs −1.796 0.578 −1.614 0.668 65.536 1.566 −0.002 11.37 0.525 −0.159 0.334 4.280 0.11
−1.40 2.24 −12.63 5.93 5.42 7.54 −2.07 2.67 1.60 −0.78 2.89 0.04
Industrials −3.583 0.504 −1.742 0.910 27.374 1.086 −0.002 21.39 0.652 −0.104 0.521 4.180 0.06
−3.37 4.22 −37.88 10.44 2.16 7.91 −2.05 2.67 2.36 −0.88 9.05 0.04
Oil and gas 0.612 0.059 −2.333 0.553 35.790 1.196 −0.001 6.211 1.418 −1.348 0.629 3.050 0.01
2.65 1.25 −42.19 6.21 3.02 7.38 −1.75 1.08 1.10 −1.00 3.25 0.08
Real estate −2.145 0.650 −1.896 0.664 91.896 0.898 −0.003 3.598 0.634 −0.564 0.733 8.070 0.10
−2.20 3.40 −12.48 8.65 5.62 5.79 −2.84 2.12 2.34 −2.22 18.80 0.00
Travel −6.406 1.179 −2.654 0.916 31.897 1.944 −0.007 25.08 0.533 −0.406 0.513 201.1 0.17
−33.58 45.20 −22.77 8.79 2.66 9.81 −14.18 52.88 7.24 −5.03 16.99 0.00
Utilities −3.176 1.426 −2.104 0.443 −25.496 0.904 −0.005 1.390 0.072 −0.040 0.841 13.84 0.12
−2.35 3.97 −12.24 3.35 −1.55 3.56 −3.72 2.94 3.21 −2.10 25.57 0.00
Notes: The dependent variable is monthly stock return Rit; the s^ it is the conditional volatility from the threshold GED-GARCH (1, 1)-M model. VaRt is the downside risk
(Bali et al., 2009). The original VaRts are multiplied by −1 before running regressions. ΔSENTt−1is change of sentiment, ΔLIQt−1 is change of trading turnover. o; e2t
1
and s2t
1 are constant, lagged shock squared, and lagged conditional variance of market returns. D is a dummy variable, which is set to unity2
as a negative shock occurs
and zero otherwise. w21 tests restriction of DEPU CN t
1 ¼ 0, where ΔEPU is the natural
2
log-difference of economic policy uncertainty. The R is the adjusted R2. The first
2
row is the estimated coefficient, the second row is the estimated t-statistics. R is the adjusted R
 US 2
Sector C s^ it VaRt VaRt−1 ΔSENTt−1 ΔLIQt−1 DEPU CN
t
1 DEPU t
1 ω e2t
1 gDe2t
1 s2t
1 Q(12) w21 w22 R

Basic_M 1.219 1.253 −2.279 0.935 44.480 1.588 −0.009 −0.017 1.386 0.366 −0.219 0.776 16.290 9.130 44.24 0.15
−3.10 3.23 −17.55 13.77 2.14 14.52 −5.84 −3.02 0.96 1.44 −0.74 6.04 0.18 0.00 0.00
Cons_Svs −10.45 2.435 −2.118 0.560 83.673 1.778 −0.004 −0.006 6.300 0.096 −0.087 0.721 18.650 45.990 174.0 0.18
−5.48 4.86 −19.17 5.48 7.30 11.19 −2.50 −2.11 3.36 3.10 −2.74 13.98 0.07 0.00 0.00
Financial −11.43 1.103 −1.154 0.819 31.509 2.413 −0.002 −0.021 5.101 0.536 −0.377 0.542 9.85 665.2 719.3 0.17
−3.92 8.26 −162.4 50.14 25.08 192.84 −15.94 −25.79 3.97 24.16 −15.21 65.02 0.63 0.00 0.00
Finan_Svs −3.157 0.866 −1.920 0.523 108.930 1.311 −0.009 −0.023 4.435 0.203 −0.220 0.793 7.580 17.050 63.07 0.08
−1.33 2.01 −8.23 3.05 4.79 4.52 −5.47 −4.13 2.42 1.79 −1.70 15.62 0.82 0.00 0.01
Ind.Gds-Svs −6.089 1.103 −2.309 0.839 42.484 1.192 −0.006 −0.006 32.85 0.555 −0.284 0.168 12.370 6.800 59.03 0.07
−1.77 2.27 −67.25 12.69 3.86 9.01 −7.44 −2.61 3.46 1.91 −1.50 3.18 0.34 0.01 0.00
Industrials −0.878 0.359 −1.774 0.742 16.578 1.753 −0.004 −0.011 4.678 0.811 −0.351 0.577 19.490 4.170 12.55 0.08
−1.79 4.04 −9.68 7.03 0.92 7.03 −2.78 −2.04 1.81 2.29 −1.37 6.32 0.08 0.04 0.00
Oil and gas −0.734 0.835 −2.350 0.586 80.910 1.502 0.004 −0.017 1.182 0.165 −0.164 0.793 10.100 3.890 5.960 0.14
−0.68 2.18 −8.72 2.17 2.57 3.22 1.53 −1.97 1.72 1.79 −1.77 7.19 0.61 0.05 0.05
Real estate −15.923 1.701 −2.794 1.173 87.580 1.211 −0.004 −0.025 46.79 0.368 0.025 0.512 13.240 205.04 389.0 0.05
−8.38 6.07 −22.20 13.59 8.64 8.28 −3.00 −14.32 3.39 3.45 0.40 20.38 0.35 0.00 0.00
Travel −3.354 0.678 −3.295 0.692 16.657 2.137 −0.005 −0.025 14.05 0.440 −0.568 0.808 16.580 262.68 677.6 0.11
−1.00 1.97 −43.08 11.33 2.20 32.43 −8.66 −16.21 2.69 1.69 −1.81 55.00 0.17 0.00 0.00
Utilities −1.589 0.957 −1.895 0.424 −1.757 0.970 −0.004 −0.005 0.871 0.107 −0.099 0.867 11.390 4.150 12.46 0.11
−1.66 3.32 −11.75 3.02 −0.10 4.20 −2.51 −2.04 2.73 2.48 −1.90 37.60 0.50 0.04 0.00
Notes: The dependent variable is monthly stock return Rit. The s^ it is the conditional volatility from the threshold GED-GARCH (1, 1)-M model. VaRt is the downside risk
(Bali et al., 2009). The original VaRts are multiplied by −1 before running regressions. ΔSENTt−1 is change of sentiment, ΔLIQt−1 is change of trading volume turnover.
o; e2t
1 and s2t
1 are constant, lagged shock squared, and lagged conditional variance of market returns. D is a dummy variable, which is set to unity as a negative shock
occurs and zero otherwise. Q(12) is the Ljund–Box Q statistics for testing the autocorrelations of the model residuals up to 12 orders. w21 tests the restriction of
S 2 CN US
DEPU U t
1 ¼ 0 and w2 tests the incremental efficiency of DEPU t
1 ¼ DEPU t
1 ¼ 2
0, where ΔEPU is the natural log-difference of economic policy uncertainty. The
first row is the estimated coefficient, the second row is the estimated t-statistics. R is the adjusted R2
uncertainty
and expected
returns
Financial risk,

innovations with a
uncertainty
stock returns on

GED-TGARCH-M
Estimates of sectoral
Table VI.

model
economic policy
China and USA
sentiment, liquidity,
downside risk,
conditional volatility,
CFRI suggesting a price reversal in the subsequent month. Note that the magnitude of price
recovery is less proportionate to the price fall in the previous period, as the estimated
coefficients of VaRt−1 are uniformly smaller than that of VaRt. It should be mentioned that
the nature of downside risk differs from the risk derived from conditional standard
deviation. This is because the VaRt−1 is derived from the largest price loss in daily trading
of the previous month; this price shock tends to create some fear in investors’ decision
making, while the s^ it is generated from sector ith conditional variance using monthly
sectoral returns in projecting future volatility. This model thus features a mixed frequency
data sampling (MIDAS) for predicting stock returns (Ghysels et al., 2005).
Third, the sign of ΔSENTt−1 on stock returns is positive, but estimated coefficients vary
across different sectors, ranging from the lowest value in Utilities sector, which is
insignificant, to the highest value in financial service sector. However, this finding for the
Utilities sector is comparable to the investigation of the US stock market by Borovkova and
Lammers (2018), who find news sentiment has an insignificant effect for all quantiles of
stock returns in Utilities sector.
Fourth, the theory predicts that the sign on ΔLIQt−1 is positive. The estimated
coefficients are in line with this priori prediction and all of the t-statistics are significant at
1 percent level. The testing results suggest that an increase in liquidity predicts a rise in
stock returns across different sectors. This finding is in line with Amihud (2002), and Chiang
and Zheng (2015). It is also interesting to point out that the Utilities sector has the smallest
value of the coefficient and the Financial sector turns out to have the largest one.
Fifth, the estimated results for the EPUs are impressive. With the exception of the
DEPU CN t
1 coefficient in the Oil and Gas sector, the signs for all other estimated coefficients
are negative and are statistically significant; this hold true for both DEPU CN t
1 and
DEPU U S
t
1 . These results indicate that a rise in uncertainty, regardless of whether it is
coming from the domestic market or the US, will predict a down turn of the sectoral
stock returns. However, the evidence shows that the price decline is more sensitive to
news from the US market. While further testing the joint significance of both
DEPU CN US
t
1 ¼ DEPU t
1 ¼ 0, the null is rejected by w2 test at 1 percent level of
2

significance. In sum, the evidence from the sectoral studies is consistent with the results
from the aggregate market with the exception of a few cases.

5. Robustness tests
5.1 Evidence of China EPU and US EPU on excess returns
The above empirical estimations clearly show that stock returns are significantly correlated
with the measures of financial risk and EPU innovations using a GED-TARCH(1, 1) model.
However, financial literature (Chen et al., 2017) contends that it is the excess stock return
rather than the stock return that should be used as the dependent variable in connecting the
risk factors when attempting to substantiate the risk premium. Thus, it is worth testing
whether the parametric relations are still valid when stock return is replaced by the excess
stock return, which is defined by subtracting one-month risk free rate from the stock return,
that is, Rm,t−rf,t−1. The results of using (Rm,t−rf,t−1) as a dependent variable in estimating
aggregate (SHSE-A share) data are reported in the top row of Table VII and are followed by
the estimates applying to sectoral data.
The estimated results in Table VII are robust. For the aggregate data (SHSE_A), all the
coefficients show signs as anticipated and are statistically significant. The evidence is
consistent with the results obtained earlier. However, there are some variations on the
estimated coefficients across different sectors. For the key risk variables, such as s^ t and
VaRt−1, the estimated results exhibit positive signs and are statistically significant,
supporting the positive risk aversion behavior for investors in China’s markets. The only
 US 2
Market C s^ t VaRt VaRt−1 ΔSENTt−1 ΔLIQt−1 DEPU CN
t
1 DEPU t
1 ω e2t
1 gDe2t
1 s2t
1 Q(12) w21 w22 R

SHSE_A −7.083 1.268 −2.213 0.751 66.281 1.716 −0.006 −0.013 34.787 0.387 −0.037 0.066 11.04 93.64 195.2 0.09
−3.84 3.23 −98.31 16.48 22.35 42.11 −11.79 −9.68 3.86 2.22 −0.63 2.85 0.44 0.00 0.00
Basic_M −1.126 0.642 −2.190 0.506 35.257 1.746 −0.010 −0.013 2.784 0.338 −0.250 0.729 12.618 36.922 79.100 0.14
−0.92 2.22 −13.83 4.07 1.85 11.15 −6.22 −6.08 1.90 1.80 −1.47 10.77 0.39 0.00 0.00
Cons_Svs −11.44 2.244 −2.584 0.225 68.198 1.704 −0.002 −0.017 14.160 0.313 −0.256 0.614 16.191 55.924 96.235 0.17
−10.52 7.47 −38.51 2.62 7.64 14.86 −3.48 −7.48 3.21 3.83 −3.44 21.34 0.13 0.00 0.00
Financial −7.827 1.258 −1.073 0.737 90.741 2.126 −0.002 −0.035 25.243 0.508 −0.292 0.326 9.845 36.864 329.508 0.18
−2.10 2.18 −17.66 8.78 10.36 16.81 −3.96 −17.52 3.52 1.62 −1.46 9.45 0.63 0.00 0.00
Finan_Svs −1.172 0.488 −2.190 0.612 95.296 1.119 −0.008 −0.023 3.794 0.449 −0.438 0.740 8.162 24.252 66.882 0.09
−1.09 2.27 −10.22 3.77 4.36 4.20 −5.89 −4.92 2.05 2.27 −1.96 11.76 0.77 0.00 0.00
Ind.Gds-Svs −0.857 0.660 −2.070 0.288 55.670 1.330 −0.002 −0.012 4.198 0.743 −0.337 0.484 15.347 7.408 19.418 0.17
−0.82 2.42 −12.87 2.98 3.70 5.54 −1.88 −2.72 2.20 2.03 −1.53 6.62 0.17 0.00 0.00
Industrials −1.733 0.339 −1.816 0.833 62.081 0.333 −0.002 −0.007 13.792 1.493 −0.795 0.358 15.781 3.750 11.940 0.07
−2.16 2.42 −25.15 13.81 4.54 2.37 −2.10 −1.94 2.34 1.77 −1.55 5.30 0.20 0.05 0.00
Oil and gas −1.708 0.664 −1.652 0.603 48.016 2.311 −0.002 −0.007 6.157 0.530 −0.259 0.543 11.265 3.580 21.120 0.13
−1.12 1.93 −15.85 5.18 3.78 22.69 −1.87 −1.89 2.59 1.44 −1.23 6.28 0.51 0.06 0.00
Real estate 2.090 −9.821 −2.303 0.781 65.409 1.108 −0.004 −0.015 23.053 0.182 −0.003 0.137 14.805 3.182 5.946 0.04
4.11 −3.22 −11.03 4.54 2.77 3.23 −1.66 −1.78 3.72 2.54 −0.05 1.28 0.25 0.08 0.05
Travel −11.407 1.741 −2.875 1.039 10.484 1.342 −0.005 −0.020 13.672 0.116 −0.311 0.741 14.313 36.879 52.980 0.11
−4.14 4.45 −39.12 13.08 0.56 8.78 −3.81 −6.07 3.45 3.22 −2.99 27.48 0.28 0.00 0.00
Utilities −0.877 0.398 −1.732 0.354 −19.727 1.387 −0.002 −0.005 2.546 0.261 −0.077 0.809 11.203 60.801 223.474 0.05
−1.70 4.78 −30.60 8.89 −2.71 13.76 −1.94 −7.80 2.22 3.26 −0.56 36.46 0.51 0.00 0.00
Notes: The dependent variable is monthly excess stock return for sector i (Rit−rf, t−1). The s^ t is the conditional volatility from the threshold GED-GARCH (1, 1)-M model
applied to market or sector i. VaRt is the downside risk (Bali et al., 2009). The original VaRt s are multiplied by −1 before running regressions. ΔSENTt−1 is change of
sentiment, ΔLIQt−1 is change of liquidity. o; e2t
1 and s2t
1 are constant, lagged shock squared, and lagged conditional variance of market returns, respectively. D is a
dummy variable, which is set to unity as a negative shock occurs and zero otherwise. Q(12) is the Ljund–Box Q statistics for testing the autocorrelations of the model
2 CN US
residuals up to 12 orders. w21 tests restriction of DEPU US
t
1 ¼ 0; w2 tests the incremental efficiency of DEPU t
1 ¼ DEPU t
1 ¼ 0, where ΔEPU is the log-difference 2
of economic policy uncertainty. The numbers in the first row are the estimated coefficients, the numbers in the second row are the estimated t-statistics. R is the
2
adjusted R
uncertainty
and expected
returns
Financial risk,

Robustness test of

liquidity, China and

USAΔEPUs
risk, sentiment,
on conditional
excess stock returns
Table VII.

volatility, downside
CFRI exception is the real estate sector whose signs in intercept and conditional volatility deviate
from the expected direction due to its sensitivity to the interest rate movements.
With respect to the EPU, all the estimated coefficients present negative signs and are
statistically significant. Once again, the magnitude of the US EPU in the absolute term is much
greater as compared with that of China, signifying different effects on China’s stock returns
depending on whether news is coming from the USA or China. The significant negative sign for
the EPU innovations suggests that a rise in uncertainty would interrupt trade or production.
The development of vulnerability of financial markets leads to a rise of fear, which causes a
selloff in stocks by investors. As a result, an increase in EPU causes stock prices to fall (Bloom,
2009; Caggiano et al., 2014). In tandem, if the EPU shocks occur in the US market, the contagious
effect is likely to create profound market disturbance on Chinese markets due to cross EPU
spillovers (Klößner and Sekkel, 2014). This, in turn, causes a decline in the stock returns in
China’s markets[10]. Of course, the impact depends on the degree of market integration and the
sensitivity of the risk aversion of investors (Bekaert and Harvey, 1995; Chen et al., 2018).

5.2 Evidence of GEPU on excess returns

In a globally integrated financial system, a shock in one market is soon learned and
transmitted to other countries, prompting investors to reassess their portfolio position
(Chiang et al., 2007; Forbes, 2012). This uncertainty would create fear that leads investors to
adjust their portfolio compositions and causes domestic stock prices to decline. For this
reason, it is of interest to consider the global EPU (GEPU) impact on China’s excess stock
returns. Since the construction of the GEPU includes an uncertainty component for China
and the statistic in Table II indicates the correlation coefficient that reaches 0.7598, it would
be more appropriate to generate the DEPU GxCN t , which is the residual series, by regressing
DEPU Gt on the DEPU CN t . The estimated results that incorporate the DEPU t
GxCN
as an
argument are reported in Table VIII.
The estimated results in Table VIII highlight the significance of two different types of
risks: s^ t and VaRt−1 and two different measures of uncertainty shocks: DEPU CN t
1 and
DEPU GxCN
t
1 . With minor exceptions, these variables demonstrate signs as anticipated.
Interestingly, each variable provides unique information that is pertinent in explaining
excess stock returns. To illustrate, s^ t represents the conditional volatility predicted by the
past monthly excess stock returns and shock squared from the GED-TARCH(1, 1) process.
This variable is an expected component of conditional volatility and features a relative
smoothing process; VaRt−1 is the downside risk of the market, capturing the shock of the
left tail of return distributions. The evidence from Table VIII clearly indicates that all
estimated coefficients of s^ t and VaRt−1are positive and significant at standard levels. The
exception is the Travel sector for the s^ t . The unanticipated sign of the coefficient in this
sector may result from the spurious correlations of unknown variables.
Next, the coefficients for the uncertainty variables, DEPU CN GxCN
t
1 and DEPU t
1 , are all
negative and statistically significant. Exceptions are the oil and gas and real estate sectors
for China and the Industrials sector for the global uncertainty. These results in general
conform to our prior anticipation – a rise in uncertainty will cause stock prices to plunge.
Our evidence is in line with the literature by Sum (2012) and Klößner and Sekkel (2014).
In addition to the reported t-statistics, we also conduct LM tests. w21 tests the
restriction of DEPU GxCN t
1 ¼ 0 and w22 tests the joint hypothesis of
DEPU CN t
1 ¼ DEPU GxCN
t
1 ¼ 0. The statistics from w21 and w22 indicate that the nulls are
rejected decisively, confirming the significant contribution that uncertainty shocks have on
the excess stock returns, no matter whether the shocks are from China’s market or from the
global market. These findings hold true at both aggregate market and sectoral level. The
empirical results are consistent with the findings of Tsai (2017) and Chiang (2019a) in that
the domestic markets are vulnerable to the EPU innovation from global markets.
 GxCN 2
Market C s^ t VaRt VaRt−1 ΔSENTt−1 ΔLIQt−1 DEPU CN
t
1 DEPU t
1 ω e2t
1 gDe2t
1 s2t
1 Q(12) w21 w22 R

SHSE-A −1.721 0.384 −1.455 0.529 94.764 1.452 −0.006 −0.008 2.086 0.615 −0.363 0.875 12.19 62.42 425.4 0.15
−1.92 2.63 −34.03 14.19 25.54 16.29 −20.63 −7.90 1.39 1.97 −1.87 91.43 0.43 0.00 0.00
Basic_M −3.031 1.111 −2.362 0.479 8.390 1.755 −0.009 −0.017 8.644 0.628 −0.539 0.380 12.890 14.600 54.523 0.16
−1.44 2.33 −14.57 3.35 0.40 7.17 −6.51 −3.82 3.09 1.82 −1.75 4.55 0.38 0.00 0.00
Cons_Svs −2.697 0.925 −2.656 0.520 77.930 0.886 −0.008 −0.010 14.873 0.867 −0.550 0.326 14.687 13.928 99.765 0.17
−1.72 3.03 −26.50 5.15 6.34 5.72 −9.95 −3.73 3.45 1.94 −1.73 6.45 0.20 0.00 0.00
Financial −0.728 0.361 −1.604 0.446 79.873 2.265 −0.001 −0.024 4.022 0.786 −0.309 0.661 11.734 514.92 516.67 0.12
−0.95 2.39 −16.21 7.54 11.96 28.78 −2.81 −22.69 1.68 1.98 −1.45 11.26 0.47 0.00 0.00
Finan_Svs −1.949 0.562 −3.318 0.885 55.228 0.457 −0.005 −0.020 5.420 0.455 −0.689 0.802 10.504 257.54 490.99 0.06
−1.49 2.65 −28.17 8.53 3.26 2.72 −3.54 −16.05 2.58 1.98 −1.98 29.50 0.57 0.00 0.00
Ind.Gds-Svs −2.753 0.806 −2.221 0.053 24.418 1.219 −0.003 −0.005 10.463 0.734 −0.216 0.525 15.988 2.862 7.375 0.15
−5.37 11.76 −23.35 0.52 2.19 8.27 −2.47 −1.69 6.45 5.49 −1.29 13.44 0.19 0.09 0.03
Industrials −4.206 1.235 −1.999 0.274 34.557 0.675 −0.004 −0.001 8.912 0.446 −0.294 0.373 17.057 0.065 6.325 0.12
−2.38 3.35 −12.11 1.71 1.50 2.14 −2.49 −0.26 3.37 2.90 −2.46 4.93 0.15 0.79 0.04
Oil and gas −2.021 0.716 −2.077 0.532 19.769 1.877 −0.000 −0.005 9.754 0.619 −0.092 0.463 12.015 4.047 5.282 0.13
−1.31 2.30 −19.94 7.50 2.15 9.18 −0.01 −2.01 2.95 1.83 −0.81 17.29 0.45 0.04 0.07
Real estate −4.362 1.468 −2.934 0.548 78.634 0.109 −0.000 −0.019 3.298 0.223 −0.186 0.756 15.961 12.135 12.628 0.13
−1.33 2.07 −14.78 2.88 4.19 0.73 −0.10 −3.48 2.53 1.77 −1.65 16.33 0.19 0.00 0.00
Travel 0.461 −6.532 −2.574 1.844 −38.963 1.601 −0.008 −0.014 105.62 0.082 −1.096 0.517 15.706 62.255 294.54 0.07
2.64 −2.53 −43.79 39.41 −4.75 20.23 −16.22 −7.89 2.25 1.14 −2.09 3.79 0.21 0.00 0.00
Utilities −7.364 1.915 −1.864 0.279 −37.519 0.617 −0.004 −0.005 10.283 0.118 −0.033 0.474 18.370 3.640 18.861 0.06
−5.41 4.24 −19.32 2.38 −3.79 3.46 −4.09 −1.91 4.01 2.41 −0.52 5.61 0.11 0.05 0.00
Notes: The dependent variable is monthly excess stock return for sector i (Rit−rf, t−1). The bs t is the conditional volatility applied to market or sector i.VaRt is the
downside risk (Bali et al., 2009). The original VaRts are multiplied by −1 before running regressions. ΔSENTt−1 is change of sentiment, ΔLIQt−1 is change of liquidity.
o; e2t
1 and s2t
1 are constant, lagged shock squared and lagged conditional variance of market returns. D is a dummy variable, which is set to one as a negative shock
occurs and zero otherwise. Q(12) is the Ljund–Box Q statistics for testing the autocorrelations of the model residuals up to 12 orders. w21 tests restriction of DEPU Gt
1 ¼ 0;
GxCN
w22 tests the incremental efficiency of DEPU CN t
1 ¼ DEPU t
1 ¼ 0, where ΔEPU is the natural log-difference of economic policy uncertainty.
2
The numbers in the
first row are the estimated coefficients, the numbers in the second row are the estimated t-statistics. “−0.000” is a very small number. R is the adjusted R2
uncertainty
and expected
returns
Financial risk,

liquidity, China and

Robustness test on

global EPUs
risk, sentiment,
on conditional
excess stock returns
Table VIII.

volatility, downside
CFRI Before we conclude this section, it should be noted that other coefficients, such as
ΔSENTt−1(except for Travel and Utilities), ΔLIQt−1, and elements of TARCH(1, 1), all
produce very comparable results as we reported earlier. However, some of the coefficients in
the asymmetric term are unable to achieve a 10 percent level of significance although the
negative sign presents. This could result from the inclusion of the VaRt−1 in the mean
equation; this variable has already effectively captured the negative shock of the bad news
from the stock markets.

5.3 Different measures of Chinese stock indices

The empirical results presented so far are based on the data of Shanghai-A shares (SHSE-A).
The rationale for employing this data set is based on its popularity, the enormity of its size
in stock market (Hu et al., 2018) and its wide use among researchers (Wong et al., 2006; Liu
and Girardin, 2007; Wang and Di Iorio, 2007; Tsai, 2017; Chiang, 2019b). In deviating from
the SHSE-A, this study also employs: the SHSE-C – Shanghai composite index from IFS
(International Financial Statistics database by IMF); A-TMT – China A share market
excluding telecom, media, and technology; A-RESO – China A-Datastream-Market
excluding resources. The results are reported in Table IX labeled as Models 5.1–5.3. It is
evident that all estimated coefficients reveal consistent signs with previous estimations and
the statistical results are comparable. Thus, the model is robust across different measures of
indices in examining stock returns.

5.4 Evidence under different market conditions

It is generally recognized that asset behavior may vary during different market conditions.
This section tests the parametric impact of DEPU CN t
1 on stock returns under turbulent
periods vis-à-vis tranquil periods. Thus, the data are divided into two groups by using an
indicator variable. The test equation can be expressed as:

Rm;t ¼ b0 þ b1 s^ it þb2 V aRt þb3 V aRt
1 þb4 DSEN T t
1 þb5 DLI Qt
1 þb6 I  DEPU CN
t
1

þb7 ð1
I Þ  DEPU CN US

t
1 þb8 DEPU t
1 þet ; (6)
where I is an indicator variable that equals unity when Chinese Shanghai A-share market is in
the turbulent period, January 2007–December 2008, and zero, otherwise. The choice of this
period can be justified in Figure 1 that a bull market was up to October 2007 then turned to a
bear market in most times of 2008, the one-year volatility index climbed up to more than
50 percent (Hu et al., 2018). The estimated results for the SHSE-A aggregate market are
reported in Model 6 of Table IX. The evidence from Model 6 indicates that the estimated
coefficients are negative and statistically significant, regardless of whether the equation is
estimated during the turbulent period (I) or the tranquil period, (1−I). However, by comparing
the absolute values of the estimated coefficients and the corresponding t-statistics, the
coefficient in the turbulent period (−0.055) is more profound and its t-statistic (−7.64) is
significantly higher than the coefficient (−0.002) with t-statistic (−3.04) in the tranquil period.
This evidence is consistent with the finding reported by Debata and Mahakud (2018) who find
that EPU is significant for determining stock market liquidity in times of financial crises.

5.5 Time effects of EPU

Up to this point, ΔEPUt-1 has been used in the empirical estimations as justified by the
unit-root test. An advantage of using a log-difference of EPU is that it helps to transform
the series into a stationary process and to eliminate the first order serial correlation.
However, using a differenced form of EPU can blur the underlying impact of the EPU on
stock returns[11].
 S 2
Model C s^ t VaRt VaRt−1 ΔSENTt−1 ΔLIQt−1 DEPU CN
t
1 DEPU U
t
1 ω e2t
1 gDe2t
1 s2t
1 R
5.1 −11.470 2.058 −2.117 0.410 21.683 0.351 −0.004 −0.014 25.852 0.577 −0.197 0.308 0.20
(SHSE-C) −10.61 5.70 −52.11 7.52 3.55 2.62 −5.94 −5.14 3.35 3.14 −2.29 10.09
5.2 −14.741 1.311 −2.793 0.488 57.366 2.949 −0.003 −0.006 65.878 0.735 −0.472 0.582 0.13
(A-TMT) −9.53 5.62 −59.55 13.91 16.85 62.47 −11.91 −7.84 2.33 2.63 −2.54 92.60
5.3 −8.976 1.814 −2.436 0.725 48.776 1.679 −0.003 −0.010 16.873 0.152 0.031 0.458 0.12
(A-RESO) −2.52 2.90 −37.90 6.90 9.92 11.14 −2.64 −3.28 2.57 2.26 0.51 3.26
US 2
Model C s^ t VaRt VaRt−1t−1 ΔSENTt−1 ΔLIQt−1 I DEPU CN
t
1
ð1
I ÞDEPU CN
t
1 DEPU t
1 ω e2t
1 gDe2t
1 s2t
1 R
6 −12.936 2.661 −2.265 0.376 51.416 2.015 −0.055 −0.002 −0.019 16.857 0.221 −0.123 0.411 0.13
(SHSE-A) −6.26 5.26 −32.00 8.26 9.58 38.74 −7.64 −3.04 −21.53 3.27 3.27 −2.81 6.14
S 2
Model C s^ t VaRt VaRt−1 ΔSENTt−1 ΔLIQt−1 EPU CN
t
1
EPU CNt
2 EPU USt
1 EPU U t
2 ω e2t
1 gDe2t
1 s2t
1 R
7 −3.707 1.171 −2.061 0.473 66.197 1.248 −0.430 0.371 −0.456 0.432 2.223 0.263 −0.225 0.775 0.21
(SHSE-A) −1.74 2.85 −18.44 5.34 6.15 7.43 −3.68 3.09 −1.89 3.76 2.88 2.12 −1.98 19.03
Notes: The dependent variable from models is monthly stock return, Rt, measured by different stock indices. The SHSE-C refers to Shanghai composite index from IFS,
A-TMT is China A share market excludes telecom, media, and technology, A-RESO denotes China A-Datastream-Market excluding resources. SHSE-A refers to China
A-share market from SHSE. The variable s^ it is the conditional volatility projected by the monthly GARCH (1, 1) process; the. VaRt is the downside risk defined as the
minimum of daily stock returns in the past 21 days (Bali et al., 2009). The original VaRts are multiplied by −1 before running regressions. ΔSENTt−1 is change of
US
sentiment, ΔLIQt−1 is change of trading turnover. DEPU CN t
1 measures the economic policy uncertainty innovation in China; DEPU t
1 denotes the economic policy
uncertainty innovation in the US market. ΔEPU is the natural log-difference of economic policy uncertainty. The o; e2t
1 and s2t
1 are constant, lagged shock squared
and lagged conditional variance of market returns, respectively. D is a dummy variable,
2
which is set to one as a negative shock occurs and zero otherwise. I is an indicator
variable referring to the period of ( January 2007–December 2008) in Model 6. R is the adjusted R2
uncertainty
and expected
returns
Financial risk,

stock returns on

with a GED-TGARCH-
policy uncertainty
Robustness checks by
Table IX.

sentiment, economic
downside risk,

M model
conditional volatility,
regressing aggregate
CFRI It is useful to re-estimate the test equation by using EPU level; the results are reported in
Model 7 of Table IX. As can be seen in Model 7, the estimated coefficients of EPU CN t
1
and EPU U S CN
t
1 at lagged-one period are negative; nevertheless, the coefficients of EPU t
2 and
EPU U S
t
2 at lagged-two period are positive and the t-ratios are highly significant. Therefore,
the estimated results in Table IX are in line with those obtained earlier. Yet, the estimated
absolute values indicate that EPU CN CN
t
2 is smaller than EPU t
1 , so is the value of EPU t
2
US
US
relative to that of EPU t
1 . The evidence suggests that the negative effect at time t−1 cannot
be fully recovered by the positive effect in the subsequent period and, therefore, the net
effect shows as negative. This evidence reveals a market phenomenon that indicates when
uncertainty hits the market, it creates a negative effect at time t−1, leading to a price plunge.
However, rational traders may take advantage of lower prices to place orders. As a result of a
price rebound, a higher return can be achieved in the near future. Thus, the investment
decisions of rational traders made during a time of high uncertainty are rewarded by higher
returns. Thus, the evidence supports the EPU premium hypothesis for both Chinese
market and the US/global market. It is of interesting to compare the current model with that
proposed by Chen et al. (2017). In Chen et al.’s (2017) study, only the lagged EPU ðEPU CN t
1 Þ is
included in explaining excess stock returns in Chinese market. As a result, the positive effect,
which is shown in EPU CN t
2 , has been ignored. Moreover, the cross-market effects from
the USA/global market, EPU U S US
t
1 and EPU t
2 , are also left out of their model[12].

6. Conclusions
This paper conducts empirical analysis on the (excess) stock returns determined by
financial risk and EPU innovation in Chinese equity markets. Applying the aggregate
market and 10 sectoral data to test stock return behavior, this study reaches several
important empirical conclusions. First, testing results consistently support the risk premium
hypothesis when the risk is derived from the conditional standard deviation using the
TARCH(1, 1)-M procedure to fit the monthly stock return data. This measure of risk
captures smaller, yet smoother return variations.
Second, the evidence confirms the positive downside risk premium hypothesis when the
downside risk is derived from the greatest loss of daily trading over the past 21 trading
days. Thus, this measure of risk captures the extreme falloff of the daily stock prices.
Evidence shows that both conditional volatility and downside risk constitute different but
complementary types of stock return risks to explain excess stock returns.
Third, it has been argued that a rise in uncertainty will impede economic activities,
which, in turn, produce a negative effect on the future cash flows, causing stock prices to
fall. Recognizing that uncertainty shocks are not restricted to the risk from financial
markets, this study uses China’s EPU change to test its effect on stock returns; the results
consistently show a negative sign in the Chinese markets. This holds true for both
aggregate data and sectoral data although the supporting evidence from oil and gas sector
and real estate sector is relatively weak due to the spurious correlations.
Fourth, as indicated by the financial contagion literature (Chiang et al., 2007; Forbes,
2012), the uncertainty shocks are characterized with comovements in global markets,
suggesting that EPU shocks from an external source will soon be transmitted to the
domestic market. This study examines the changes of EPU from both the USA and global
markets (which neutralizes the China effect). The evidence suggests that in both cases,
the sign of change in uncertainty is negative and statistically significant. However, the
evidence suggests that the external source of a shock, either from the USA or the global
market, has more a profound influence than that from Chinese market.
Fifth, although the uncertainty changes reveal negative sign, the evidence implies that
stock returns are positively correlated with the longer lagged EPU. Evidence suggests that
although a rise in EPU produces a negative effect on stock returns at the time news
hits market, some investors will be rewarded by a premium as prices rebound in the subsequent Financial risk,
period, compensating them for their investment decision made at time of high uncertainty. This uncertainty
phenomenon supports both local and global uncertainty premium hypotheses. and expected
Sixth, consistent with the existing literature, both growth in investment sentiments and
growth in liquidity are included in the test equation to serve as control variables. The returns
evidence confirms that a better performance of these variables produces a positive effect on
stock returns.
Seventh, the data indicate that the GED-TARCH(1, 1)-M model is an appropriate process to
describe the monthly data in Chinese stock markets. Specifically, the coefficients on the
TARCH(1, 1) components are statistically significant, suggesting that Chinese stock returns
display a volatility clustering phenomenon. The threshold coefficients are negative, indicating
asymmetric effects on volatility as negative news hits the market. Finally, the test results are
robust across different measures of stock returns, market conditions and model specifications.

Notes
1. Hu et al. (2018) provide an excellent survey on Chinese capital market development, investment
instruments and empirical analysis.
2. The establishments of Shanghai-Hong Kong Stock Connect program in November 17, 2014 and
Shenzhen-Hong Kong Stock Connect program in December 5, 2016 help to expand China’s stocks
in global listing. The two programs now link stock exchanges with a combined market
capitalization of more than $10trillion, the second largest equity market in the world taken as a
whole (Borst, 2017).
3. Additional control variables may include dividend yield (Fama and French, 1988; Campbell et al.,
1997), change in exchange rate, and higher moments of stock returns (Chiang, 2019b). However, our
prior test cannot find significant evidence of the dividend yield; moreover, since VaR already
incorporates most information of higher moments of stock returns as implied by the Cornish–Fisher
expansion (Cornish and Fisher, 1938), the inclusion of the higher moments is not necessary.
For these reasons, we only employ ΔSENTt and ΔLIQt as the control variables.
4. Engle (1995) and Bollerslev (2010) provide different ARCH-type specifications and applications.
5. A kurtosis above 3 indicates “fat tails,” or leptokurtosis, relative to the normal or Gaussian,
distribution. Platykurtosis refers to a distribution that has a negative excess kurtosis with a
relatively flatter peak rather than a normal distribution.
6. The augmented Dickey–Fuller test statistics at the log EPU level for Chinese market is −2.164
( p ¼ 0.22), indicating the null cannot be rejected. However, after taking a difference, the t-statistic
turns to −15.12 ( p ¼ 0.00), rejecting the null.
7. Appendix 1 provides a summary of the definition of variables, measurements and sources.
8. The sentiment variable is proxied by the macroeconomic climate obtained from
Datastrean. This index is calculated based on a group of leading indicators. The indicators
for constructing the macroeconomic climate index are: the A-share turnover value on the
Shanghai Stock Exchange, the rate of sales value to gross output values, the money supply
(M2), investment (newly started projects), freight traffic, cargo handled at major seaports,
consumer expectations index, and the difference in national debt interest rates. This index, by
its construction, summarizes broad information on the business/economic conditions pertinent
to investment.
9. Knight’s distinction between risk and uncertainty has been taken on differentials between the
measurability vs immeasurability or objectivity vs subjectivity of probability. In fact, Knight
(1921) defined only quantifiable uncertainty to be risk. However, the EPU indices constructed by
Baker et al. (2016) help to quantify the measurability of uncertainty.
CFRI 10. Since the US market uncertainty is commonly measure by the St Louis Fed Stress Index (the VIX
is also included in constructing this index), we use DSTLFSI U S US
t
1 to replace DEPU t
1 for testing
the uncertainty effect. The estimated results are reported in Appendix 2. As expected, the sign of
the coefficients for DSTLFSI U S
t
1 is negative and significant across different sectors (except the
US
real estate sector). The DEPU t
1 appears to demonstrate more consistent result.
11. To illustrate, defining ΔEPUt−1 ¼ EPUt−1−EPUt−2 means that−βΔEPUt−1 ¼ −β(EPUt−1−EPUt−2)
¼ −βEPUt−1 + βEPUt−2. This shows that the coefficient of EPUt−1 is negative and coefficient of
EPUt−2 is positive. What −βΔEPUt−1 suggests is that the net effect of EPU on stock returns over
two periods is negative.
12. The evidence suggests (not reported) that the AR(1) of natural log in Chinese EPU is 0.63 (t ¼ 9.84)
and the AR(1) of the level of the Chinese EPU is 0.77 (t ¼ 12.03). By checking higher orders of the
ACF of the EPU, the coefficients of autocorrelation die down slowly and are significant at least up
to 12th order (0.253 with t ¼ 3.95). Having taken the first difference on the EPU, the unit-root test
suggests rejection of the null. However, while controlling a number of macroeconomic variables
and market uncertainty variables in their test, Chen et al. (2017) contribute to the literature by
providing out-of-sample predictions for longer time horizons.

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CFRI Appendix 1

Variable Description Source

Rm,t Market stock returns (SHSE-A or SHSE-C), which is obtained by taking natural Datastream
log-difference of stock price index times 100 IFS
Rm,t−rf,t−1 Excess stock return, which is (Stock return − one-month interest rate) Datastream
s^ t Conditional standard deviation generated by GARCH(1,1)-M model Datastream
s2t Variance of stock returns generated from GARCH(1,1)-M process Datastream
VaRt Downside risk, which is measured by the minimum value of daily stock returns Datastream
in the past 21 days (Bali et al., 2009). The original VaRts are multiplied by −1
before running regressions
EPUt Economic policy uncertainty index from Baker et al. (2016) or Davis (2016). Baker et al.
This variable was transformed by taking natural logarithm (2016)a
ΔEPUt EPU innovation measured by natural log-difference of EPU index Baker et al.
(2016)
ΔSENTt−1 Natural log-difference of sentiment measured by macroeconomic climate IFS
indicator
ΔLIQt−1 Natural log-difference of liquidity, which is measured by trading volume Datastream
turnover
DSTLFSI Ut
S Change in the US financial market fear index
St Louis Fedb
et Random shock
Ωt−1 Information set conditional on time t–1
GED(.) Generalized error distribution
SHSE-A China Shanghai Stock Exchange-A share index Datastream
SHSE-C China Shanghai composite index IFS
A-TMT China A share market excludes telecom, media and technology Datastream
A-RESO China A-Datastream-Market excluding resources Datastream
Table AI. Note: awww.policyuncertainty.com Website information has been updated to current
Summary of Sources: “Measuring Economic Policy Uncertainty” by Scott Baker, Nicholas Bloom and Steven J. Davis at
notations of variables www.PolicyUncertainty.com; bhttps://fred.stlouisfed.org/series/STLFSI
 2
Appendix 2
US
Market C s^ t VaRt VaRt−1 ΔSENTt−1 ΔLIQt−1 DEPU CN
t
1 DSTLFSI t
1 ω e2t
1 gDe2t
1 s2t
1 Q(12) w21 w22 R

Aggregate −1.850 0.730 −1.729 0.381 57.322 1.828 −0.001 −0.050 8.507 0.574 −0.455 0.471 14.92 67.23 71.53 0.18
−1.46 2.64 −29.17 4.26 9.20 23.66 −2.73 −8.20 2.95 1.96 −1.87 5.50 0.25 0.00 0.00
Basic_M −1.838 0.816 −2.149 0.531 10.198 1.731 −0.007 −0.156 4.663 0.633 −0.572 0.593 11.671 138.67 145.104 0.16
−1.56 3.06 −13.15 3.40 0.53 8.99 −4.84 −11.78 2.60 1.99 −1.90 7.50 0.45 0.00 0.00
Cons_Svs −3.677 1.301 −2.364 0.252 96.155 1.433 −0.005 −0.298 4.396 0.423 −0.447 0.740 14.793 71.570 108.560 0.21
−7.68 10.11 −21.23 5.41 9.31 16.10 −5.15 −8.46 3.30 3.80 −3.98 26.97 0.19 0.00 0.00
Financial −1.348 0.522 −1.782 0.698 54.690 0.269 −0.004 −0.042 2.772 0.450 −0.479 0.769 9.448 2.705 9.750 0.16
−1.50 2.57 −15.06 4.51 4.09 1.38 −2.86 −1.64 2.48 1.80 −1.67 17.04 0.66 0.10 0.01
Finan_Svs −0.548 0.428 −2.014 0.335 92.706 1.714 −0.010 −0.077 3.233 0.305 −0.191 0.757 8.162 24.252 66.881 0.09
−0.57 2.27 −9.39 3.17 4.18 6.42 −6.35 −3.34 1.72 1.91 −1.38 12.43 0.77 0.00 0.00
Ind.Gds-Svs −0.790 0.539 −2.036 0.516 86.839 1.726 −0.003 −0.053 3.973 0.751 −0.333 0.503 14.657 13.146 15.925 0.15
−0.95 2.35 −16.54 3.72 8.38 7.75 −2.46 −3.63 2.27 1.92 −1.22 5.72 0.20 0.00 0.00
Industrials −0.846 0.326 −1.994 0.795 73.842 1.309 −0.006 −0.047 5.517 1.185 −0.532 0.505 17.860 29.707 33.647 0.09
−1.69 3.04 −17.11 8.00 4.46 6.42 −3.90 −5.45 1.71 2.22 −1.43 5.69 0.12 0.00 0.00
Oil and gas −0.242 0.412 −2.371 0.566 36.160 2.188 −0.002 −0.024 2.046 0.724 −0.176 0.697 10.633 18.176 41.839 0.13
−0.62 3.65 −21.65 9.71 5.42 19.01 −3.76 −4.26 2.39 2.16 −1.20 30.15 0.56 0.00 0.00
Real estate −3.332 1.016 −1.952 0.646 79.440 0.653 −0.003 −0.030 2.723 0.262 −0.206 0.768 10.596 1.268 3.271 0.10
−1.96 2.83 −9.19 3.37 3.32 2.05 −1.49 −1.13 2.15 2.16 −2.24 15.41 0.56 0.26 0.19
Travel −1.348 0.872 −2.842 1.051 19.590 2.235 −0.006 −0.057 2.326 0.189 −0.151 0.803 14.429 4.720 9.781 0.16
−0.61 1.66 −12.15 5.20 0.92 6.50 −2.44 −2.17 1.65 1.51 −1.38 11.08 0.27 0.03 0.01
Utilities −3.892 1.042 −1.979 0.478 1.599 0.938 −0.004 −0.275 3.983 0.167 −0.161 0.816 12.576 7.601 19.963 0.10
−2.04 2.76 −13.57 4.18 0.10 5.69 −3.60 −2.76 19.99 2.04 −1.55 25.32 0.40 0.00 0.00
Notes: The dependent variable is monthly excess stock return for sector i, (Rit−rf,t−1). The independent variables are the same as those in Table VIII except
S 2 US 2 CN US
DSTLFSI Ut
1 . w1 tests the restriction of DSTLFSI t
1 ¼ 0 and w2 tests DEPU t
1 ¼ DSTLFSI t
1 ¼ 0, where ΔEPU is the natural log-difference of
S US −3
economic policy uncertainty. DSTLFSI U t
1 ¼ change in the US financial market fear, the coefficients of DSTLFSI
2 t
1 should be muplier by (10) . The
numbers in the first row are the estimated coefficients, the numbers in the second row are the t-statistics. R is the adjusted R2
uncertainty
and expected
returns
Financial risk,

stock returns on
Robustness test on

fear with a GED-

uncertainty and the
sentiment, liquidity,

TGARCH-M model
US financial market
China economic policy
downside risk,
estimates of excess
Table AII.

conditional volatility,
CFRI About the author
Dr Thomas C. Chiang is Marshall M. Austin Chair Professor at Drexel University. His research interests
include global financial contagion, international finance, international asset pricing, behavioral finance,
and financial econometrics. Dr Chiang has published extensively in a number of core finance journals,
including the Journal of International Money and Finance, Journal of Banking and Finance, Quantitative
Finance, Journal of Money, Credit and Banking, Journal of Forecasting, Pacific-Basin Finance Journal,
Journal of Financial Research, Financial Review, European Financial Management, and Weltwirtschaftliches
Archiv, among others. Dr Thomas C. Chiang can be contacted at: chiangtc@drexel.edu

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