Abstract: The question whether or not investors in financial markets are rational is of great importance in finance. The rationality of Chinese stock market under extreme risk is investiated in this paper. Defining extreme risk as returns above (below) a specified threshold, a statistical indicator is proposed to investigate the market response to extreme risk. Based on daily prices of Chinese stock market index over January 1, 2002-October 28, 2013, our results demonstrate some interesting characteristics of Chinese stock market under the extreme risk:1. stock index is found to rebound in case of sharp fall in stock index;no such evidence is found in case of sharp rise in stock index;2. compared to bear market, stock index in bull market tends to rebound in case of extreme downside risk. Trading strategy based on extreme risk outperforms the simple buy-and-hold strategy, indicating the irrationality of Chinese stock market in case of extreme risk. The empirical findings demonstrate that investors in Chinese stock market is irrational and that extreme risk is an important factor in asset pricing.

Key words: extreme risk, overreaction, Chinese stock market