What Drives the Tail Risk Effect in the Chinese Stock Market?

In this paper, we reveal that in the Chinese stock market, the significant negative relationship between tail risk and expected returns only exists when excluding the bottom 30% market capitalization (small-cap) stocks, a finding that helps to reconcile the mixed result of the tail risk effect in China. In mechanism exploration, irrational biases of investors (including underreaction to bad news, preference for tail risk of stocks in capital loss, and overoptimism) and limits to arbitrage in the market may induce the negative tail risk effect in the Chinese stock market. In addition, we also find that implementing the margin trading system reduces the tail risk and suppresses the negative tail risk effect for target stocks