The Overnight Return Puzzle and the 'T+1' Trading Rule in Chinese Stock Markets

Abstract

We document a puzzling phenomenon, namely that overnight returns in Chinese stock markets are on average statistically and economically significantly negative. This finding seems to violate conventional asset pricing theory, yet the anomaly is robust to the choice of stock exchange, type of shares, and sample period, present in different market regimes (bull or bear markets), and persists across assets of small, medium, and large market capitalization. Moreover, this overnight return puzzle appears to be unique to Chinese markets. We hypothesize that a particular arrangement in Chinese stock markets explains the puzzle: the so-called "T+1" trading rule. The T+1 trading rule prohibits traders to sell shares they bought on the same the day. This asymmetric trading restriction should lead to a discount on daily opening prices. We find empirical support that the T+1 induced discount can indeed explain the overnight return puzzle, and we rule out other explanations. We estimate the average T+1 discount at 14 basis points. In addition, we establish that the T+1 discount contributes significantly to overnight risk. While the T+1 trading rule was introduced with the belief it would reduce volatility, we propose that the rule has had unintentional consequences, namely a substantial discount for opening prices and the adverse effect of increasing volatility.

Keywords: Overnight Return Puzzle, T+1 Trading Rule, T+1 Discount, Market Micro Structure

JEL Classification: G10, G12, G18