Risk and return in the Chinese stock market: Does equity return dispersion proxy risk?

•Equity return dispersion (RD) cross-sectionally drives stock returns in China.•Stocks with greater sensitivities to RD yield higher average returns.•The RD effect is robust to market, firm level effects and in industry portfolios.•RD captures the fundamental uncertainty associated with economic transitions.

We examine whether equity return dispersion, measured by the cross-sectional standard deviation of stock returns, is systematically priced in the cross-section of stock returns in China. We find that return dispersion carries a positive price of risk even after controlling for market, size, book-to-market, and idiosyncratic volatility effects. We observe that stocks with greater sensitivities to equity return dispersion yield higher average returns. The finding of a significant return dispersion effect is robust to alternative portfolio sorts based on the well-established risk factors as well as industry portfolios. We argue that equity return dispersion captures the fundamental uncertainty associated with economic transitions and the flexibility of adaptability to fundamental economic restructuring that cannot be captured by market and firm level factors. To that end, return dispersion serves as a more meaningful proxy for risk in this emerging market that has experienced a significant economic transition during much of the sample period.