| Abstract | This paper studies the effect of the Wencuan Earthquake on China’s capital markets. Using monthly stock returns within a 12-months period following the earthquake (2008.6-2009.5), this paper finds that stocks headquartered closer to the epicenter have lower stock returns. For every 1000 KM increase in the distance between the firm and the epicenter, the stock returns go up by 3% annually. In addition, the portfolio of stocks within 500 KM radius of the epicenter has significant negative abnormal returns, average -3% per month. In contrast, the portfolios of stocks outside of the 500KM radius of the epicenter do not exhibit any significant abnormal returns. Further analysis indicates that this anomaly did not exist before the earthquake. Moreover, this anomaly is not caused by the real damage of the earthquake for two reasons: First, the profitability and cash-flow ability of firms closer to the epicenter do not suffer greater damage. Second, the systematic risk of stocks is not significantly affected by the earthquake in a way consistent with the stock return pattern. Overall, this paper concludes that the impact of the earthquake on China’s capital markets is a result of investors’ psychological fear, not a result of real damage of the earthquake. |