Crash risk exposure, diversification and cost of equity capital: evidence from a natural experiment in China

Quanxi Liang and Wei Mao

Journal of Risk

Abstract: Based on a broad sample of Chinese listed firms for the period 2001–10, this study investigates the effect of stock price crash risk exposure on the cost of equity capital and uses the split share structure reform as an exogenous shock to test whether this extreme event risk can be diversified. The reform converts previously nontradable shares into tradable shares, thereby improving risk sharing among investors. We find that crash risk exposure is significantly and positively associated with the ex ante cost of equity capital, after controlling for other firm-specific determinants as well as industry, year and firm fixed effects. Moreover, we show that the positive relationship between crash risk exposure and the cost of equity capital remains unchanged after the reform, even when idiosyncratic volatility risk and its interaction with the reform are controlled. Various robustness tests confirm our main conclusions.

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