Replication of Reference-Dependent Preferences and the Risk-Return Trade-Off in the Chinese Market

TL;DR

This paper replicates and extends research on reference-dependent preferences and the risk-return trade-off in the Chinese stock market, highlighting behavioral and structural differences from developed markets through empirical analysis.

Contribution

It provides empirical evidence on how reference-dependent preferences influence stock returns in China, revealing weaker risk-return relationships and different interaction effects compared to the U.S. market.

Findings

Weaker positive risk-return relationship in high-CGO firms

Stronger positive risk-return relationship in low-CGO firms

Negative interaction effects between CGO and risk proxies in China

Abstract

This study replicates the findings of Wang et al. (2017) on reference-dependent preferences and their impact on the risk-return trade-off in the Chinese stock market, a unique context characterized by high retail investor participation, speculative trading behavior, and regulatory complexities. Capital Gains Overhang (CGO), a proxy for unrealized gains or losses, is employed to explore how behavioral biases shape cross-sectional stock returns in an emerging market setting. Utilizing data from 1995 to 2024 and econometric techniques such as Dependent Double Sorting and Fama-MacBeth regressions, this research investigates the interaction between CGO and five risk proxies: Beta, Return Volatility (RETVOL), Idiosyncratic Volatility (IVOL), Firm Age (AGE), and Cash Flow Volatility (CFVOL). Key findings reveal a weaker or absent positive risk-return relationship among high-CGO firms and stronger positive relationships among low-CGO firms, diverging from U.S. market results, and the interaction effects between CGO and risk proxies, significant and positive in the U.S., are predominantly negative in the Chinese market, reflecting structural and behavioral differences, such as speculative trading and diminished reliance on reference points. The results suggest that reference-dependent preferences play a less pronounced role in the Chinese market, emphasizing the need for tailored investment strategies in emerging economies.