Mispricing and Arbitrage Portfolios in China

Relying on a latent factor model that accommodates evident structural changes and time-varying dependence of mispricing on firm characteristics, we reveal economically substantial mispricing in the Chinese stock market. For the reasonable number of latent factors equal to 4, the arbitrage portfolio constructed from estimated mispricing can earn an out-of-sample annualized Sharpe ratio of 1.79, which cannot be explained by common factor models constructed for the Chinese stock market. We find that size and book-to-market consistently contribute to both mispricing and systematic risk over time. Mispricing is much more severe in non-state-owned, high-subsidy, and small stocks than in state-owned, low-subsidy, and large stocks. We show that mispricing in China is more severe than and has low correlation with that in the US.