Marketwide Liquidity Risk And Liquidity Premium In Shanghai A-Share Security Market

Serving as a measure to reflect how fast an asset can be traded for cash, liquidity is vital to a security market. It's also an indicator for the level of development of a country's security market. Officially started from April 29th in 2005, the equity reform on listed companies has come to its end by now, a number of shares which were used to be non-tradable will flock the A shares market after the ban period, indicating that there is a remarkable change for the marketwide liquidity of Chinese A shares market. According to the important role of liquidity on price discovery, it's quite meaningful for us to study the relationship between liquidity and asset pricing in such a transitional market of China.This paper, distinct from other literatures on the same topic, focuses on the market wide liquidity instead of individual liquidity, the risk of the former one can not be diversified. With the transition data of A shares in Shanghai security market from 1997 to 2006, ten years in all, this paper constructs two measures on market liquidity, one was suggested by Pastor and Stambaugh (2003), the other followed the method of Amihud (2002). Under a comparative framework, this paper exams the liquidity premium of A shares in Shanghai Security Market. Taking some key features of Chinese security market into consideration, the paper designs three hypotheses:H1, the first hypothesis assumes market liquidity risk can serve as a state variable in the asset pricing formula of Chinese A shares;H2, the second one supposes there are dynamic differences in asset pricing in China as the market is approaching maturity, the market liquidity risk may be better priced in a relative later period.H3, the last hypothesis assumes two liquidity measures will show different performances if one measure is system specific while the other one is not.With the methods of the portfolio test and the regression test, the empirical results support those three hypotheses powerfully. First, we find a solid ground for the existence of liquidity premium among A shares in Shanghai Security Market. Secondly, the factors underlying asset pricing in Chinese security market change as investors get more and more rational and the market grows. Thirdly, we find Amihud measure shows a better performance as a proxy for market liquidity than Pastor-Stambaugh measure does attributing to the institutional independence of Amihud measure. Since China is taking an order-driven trading system, the Pastor-Stambaugh measure, which roots in the market-maker system, might be weaker in capturing the overall liquidity risk of Chinese security market. Based on the empirical result, the paper will give some strategic suggestions to improve the marketwide liquidity in the conclusion.