Securities trading in multiple markets: the Chinese perspective

Transcription

1 Securiies rading in muliple markes: he Chinese perspecive A hesis submied for he degree of Docor of Philosophy Scoish Graduae Programme in Economics Deparmen of Economics Universiy of Sirling By Chaoyan Wang Sepember,

2 DECLARATION In accordance wih he Regulaions for Higher Degrees by Research, I hereby declare ha he whole hesis now submied for he candidaure of Docor of Philosophy is a resul of my own research and independen work excep where reference is made o published lieraure. I also hereby cerify ha he work embodied in his hesis has no already been submied in any subsance for any degree and is no being concurrenly submied in candidaure for any degree from any oher insiue of higher learning. I am responsible for any errors and omissions presen in he hesis. Candidae: Chaoyan Wang 2

3 Absrac This hesis sudies he rading of he Chinese American Deposiories Receips (ADRs) and heir respecive underlying H shares issued in Hong Kong. The primary inenion of his work is o invesigae he arbirage opporuniy beween he Chinese ADRs and heir underlying H shares. This inenion is moivaed by he marke observaion ha hedge funds are ofen in he op 10 shareholders of hese Chinese ADRs. We sar our sudy from he origin place of he Chinese ADRs, China s sock marke. We pay paricular aenion o he ownership srucure of he Chinese lised firms, because par of he Chinese ADRs also lised A shares (exclusively owned by he Chinese ciizens) in Shanghai. We also pay aenion o he marke microsrucures and rading coss of he hree China-relaed sock exchanges. We hen proceed o empirical sudy on he Chinese ADRs arbirage possibiliy by comparing he reurn disribuion of wo securiies; we find hese wo securiies are differen in heir reurn disribuions, and which is due o he inequaliy in he higher momens, such as skewness, and kurosis. Based on he law of one price and he weak-form efficien markes, he prices of idenical securiies ha are raded in differen markes should be similar, as any deviaion in heir prices will be arbiraged away. Given he inrinsic propery of he ADRs ha a convenien ransferable mechanism exiss beween he ADRs and heir underlying shares which makes arbirage easy; he differen reurn disribuions of he ADRs and he underlying shares address he quesion ha if arbirage is cosly ha he equilibrium price of he securiy achieved in each marke is affeced mainly by is local marke where he Chinese ADRs/he underlying Hong Kong shares are raded, such as he demand for and he supply of he sock in each marke, he differen marke microsrucures and marke mechanisms which 3

4 produce differen rading coss in each marke, and differen noise rading arose from asymmeric informaion across muli-markes. And because of hese rading coss, noise rading risk, and liquidiy risk, he arbirage opporuniy beween he wo markes would no be exploied promply. This concern hen leads o he second inenion of his work ha how noise rading and rading cos comes ino playing he role of deermining asse prices, which makes us o empirically invesigae he comovemen effec, as well as liquidiy risk. Wih regards o hese issues, we progress ino wo srands, firsly, we es he relaionship beween he price differenials of he Chinese ADRs and he marke reurn of he US and Hong Kong marke. This es is o examine he comovemen effec which is caused by asynchronous noise rading. We find he US marke impac dominan over Hong Kong marke impac, hough boh markes display significan impac on he ADRs price differenials. Secondly, we analyze he liquidiy effec on he Chinese ADRs and heir underlying Hong Kong shares by using wo proxies o measure illiquidiy cos and liquidiy risk. We find significan posiive relaion beween reurn and rading volume which is used o capure liquidiy risk. This finding leads o a deeper sudy on he relaionship beween rading volume and reurn volailiy from marke microsrucure perspecive. In order o verify a proper model o describe reurn volailiy, we carry ou es o examine he heeroscedasiciy condiion, and proceed o use wo asymmeric GARCH models o capure leverage effec. We find he Chinese ADRs and heir underlying Hong Kong shares have differen paerns in he leverage effec as modeled by hese wo asymmeric GARCH models, and his finding from anoher angle explains why hese wo securiies are unequal in he higher momens of heir reurn disribuion. We hen es wo opposie hypoheses abou volume-volailiy relaion. The Mixure of 4

5 Disribuions Hypohesis suggess a posiive relaion beween conemporaneous volume and volailiy, while he Sequenial Informaion Arrival Hypohesis indicaes a causaliy relaionship beween lead-lag volume and volailiy. We find supporive evidence for he Sequenial Informaion Arrival Hypohesis bu no for he Mixure of Disribuions Hypohesis. 5

6 Acknowledgemens Compleing a PhD degree has been one of my dreams since I was in high school, and i ook almos four years in he making and even longer of waiing and preparing o ge a chance o do PhD in my favourie area. I have all along known ha my dream would no have been possible o come rue wihou Dr. Dipak Ghosh, who is my principle supervisor however has given me suppor, encouragemen, and guidance in every sense ha is far more han wha a supervisor needs o do. So, I would like o give my hearies and sinceres hanks o my Dear Dipak. I always remember he said Somehing will happen! when I was in my very difficul ime ha I was almos hinking of giving up. His smile and his eyes gliering of wisdom are always kep in my mind and in my hear ha reminds me o work hard. Compleing a PhD is never an end bu a sar of my academic life, any effor I make is no only for me bu also for Dear Dipak, and any honour I will earn is owned o my Dear Dipak. I would also like o offer my sinceres hanks o my parens, Shengchao Wang and Hui Wang, for heir paience and olerance over his lenghy process and he long absences. Alhough my moher was worried a Dr. ile may be oo much for a young lady, she is now so proud of her daugher. I fear any enumeraion of he people who deserve acknowledgemen will ineviably be incomplee. Ye, wo individuals have also made imporan conribuion upon he compleion of his hesis, Professor Sheila Dow and Professor David Bell. Wihou Sheila whose name I have known when I was sill in China, I would no have sared my PhD life in Sirling Universiy. Wihou David who gave some criical suggesions, his hesis would appear less convincible and canno be read. I am so 6

7 graeful o hem ha hey are always available and always supporive when I come o hem wih quesions even hey are always busy, and all heir commens are appreciaed. Also I wan o show my graiude o Malay Dey, who made a srong impression on me by vividly showing me wha a smar senior researcher is like and helping me o shape my fuure. This is also hanks o his lovely wife Bharai Dey ha boh of who offered me a grea research rip o he US, a cozy room in heir beauiful house in Connecicu, and delicious Indian food. I would also like o offer my hanks o colleagues in Sirling Universiy and friends in Edinburgh Universiy, wih hose whom, he casual chas uninenionally sparked some new idea. A large dose of graiude is due o Dr. Xiao Qiao who has been unfalering in his encouragemen. I am also especially graeful for he generous financial suppor provided by he Deparmen of Economics in Sirling Universiy allowing me be par of a fanasic learning environmen. Finally, I would also like o hank he exernal examiner, Professor Seh Armiage, for very helpful suggesions on my work. 7

8 Conens Absrac... 3 Acknowledgemens...6 Lis of Tables Lis of Graphs Lis of Abbreviaions Chaper Inroducion Chaper A Survey of China s Sock Marke Inroducion The Chinese Lised Companies, Impac of Ownership Srucure on China s Sock Marke A Brief Hisory of China s Sock marke The Feaures of China s Sock marke Non-radable Shares Ownership Problems Hardening of he Budge Consrains and Non-radable Shares Reform The segmened marke wih price puzzle A shares B shares H shares Sock Exchanges, Transacion Coss, and Trading Mechanisms Transacion Coss and Liquidiy Trading mechanisms Transacion coss of hree China-relaed sock exchanges SHSE, SZSE, and SEHK Conclusions 68 Chaper 3 71 Lieraure Review on ADRs and Relaed Topics Inroducion American Deposiory Receips (ADRs) Firms moivaions for cross lising Price discovery process of he ADRs The segmened marke hypohesis The cos of capial The price discovery Arbirage opporuniy and he limis of arbirage Arbirage possibiliy The limis of arbirage Lieraure review on liquidiy Wha is liquidiy How o measure liquidiy 89 8

9 3.6.3 Liquidiy risk and liquidiy level Trading volume and liquidiy risk Conclusion 92 Chaper Reurns Spread and Liquidiy of he Chinese ADRs Inroducion Overview of he Chinese American Deposiory Receips (ADRs) Research Mehodology and Hypohesis Developmen To es he law of one price To es he comovemen effec on mispricing To es he liquidiy effec on mispricing Daa and descripive saisics Daa The Chinese ADRs lising hisory and lising paern Descripive saisics on ADRs and H shares reurns Empirical ess and resuls Tess on he law of one price Tess on he comovemen effec on he mispricing Tes on he liquidiy effec Srucural change Conclusion 150 Chaper Volume-Volailiy in Dual Markes: Lessons from he Chinese ADRs Inroducion Lieraure Review The Mixure Disribuion Hypohesis The Sequenial Informaion Arrival Hypohesis Research mehodology and hypohesis developmen Model selecion for reurn volailiy De-rend Trading volume Tes MDH Tes SIAH Daa and empirical resuls Daa Resuls of model selecion for reurn volailiy Resuls of he es on he MDH Resuls of he es on he SIAH Conclusions 183 Chaper Conclusion Bibliography

10 Lis of Tables Chaper 2 Table 2.1 Chronology of he hisorical evens of he China s sock marke 17 Table 2.2 Raio of Marke Capializaion o GDP in China 24 Table 2.3 Turnover raio of radable A shares in SHSE and SZSE 24 Table 2.4 Chronology of sae-owned shares reform 29 Table 2.5 Explici coss of he SHSE, SZSE and HKSE (2006) 45 Table 2.6 Marke impac coss on he SHSE for one ransacion value 46 Table 2.7 Marke impac coss on he SHSE for hree ransacion values 46 Table 2.8 Marke impac coss on he SHSE, HKSE, NYSE, and NASDAQ 46 Table2.9 Marke condiion, Trading hours and Trading days of hree exchanges 49 Chaper 4 Table 4.1 overview of he Chinese ADRs lised on he NYSE and NASDAQ as of Ocober Table 4.2 Overview of he Chinese lised firms indusry disribuion (2006) 100 Table 4.3: Descripive saisics on daily reurns 101 Table 4.4: Saisical disribuion of reurns spread 103 Table 4.5: Equaliy ess on reurns of he ADRs and H shares 104 Table 4.6: F-es for join means and variance ess 107 Table 4.7: Summary of es resuls of Tables 4.5 and Table 4.8: Pearson and Spearman correlaion es 117 Table 4.9: Resuls of ime series regression analysis 120 Table 4.10: F es on join equaliy of mean and variance beween wo porfolios 123 Table 4.11: Descripive saisics of liquidiy proxies

11 Table 4.12: Liquidiy effecs 127 Table 4.13: Srucural change 132 Chaper 5 Table 5.1. The Ljung-Box Q saisics 161 Table 5.2. Volailiy persisence wihou volume 163 Table 5.3. Conemporaneous volume-volailiy relaion es wih rading volume 166 Table 5.4. Granger causaliy beween volume and volailiy

12 Lis of Graphs Chaper 4 Graph 4.1: Yearly ADR lising by Hong Kong firms during he sample period 98 Graph 4.2: Q-Q (Quarile-Quarile) plos

13 Lis of Abbreviaions AMS Auomaic Order Maching and Execuion Sysem CSDCC China Securiies Deposiory and Clearing Corporaion Ld CSRC China Securiies Regulaory Commission GAAP Generally Acceped Accouning Principles HKSAR Hong Kong has been a special adminisraive region of China HKSCC Hong Kong Securiies Clearing Co Ld IAS Inernaional Accouning Sandards IFC Inernaional Finance Corporaion IPO Iniial Public Offering LP Legal Person M&A Mergers & Acquisiion MBO Managemen Buy-Ou MDH Mixure of Disribuions Hypohesis NAV Ne Asse Value OTC Over-The-Couner PBOC People's Bank of China QDII Qualified Domesic Insiuional Invesors QFII Qualified Foreign Insiuional Invesor RMB Renminbi SASAC Sae-owned Asses Supervision and Adminisraion Commission of he Sae Council SEC Securiies and Exchange Commission SEHK Sock Exchange of Hong Kong SIAH Sequenial Informaion Arrival Hypohesis SHSE Shanghai Sock Exchange SOEs Sae Owned Enerprises SZSE Shenzhen Sock Exchange 13

14 Chaper 1 Inroducion Wha deermines asse prices? The sandard heory in financial economics, he Efficien Marke Hypohesis (EMH), argues prices are always consisen wih he fundamenals ; and equilibrium prices are passively achieved by he marke, because an efficien marke should fully reflec all available informaion (Fama, 1991). This implies ha he marke processes informaion raionally, in he sense ha relevan informaion is no ignored, and sysemaic errors are no made. Based on he EMH, in he classic asse pricing heory, he fundamenal value of an asse is measured by he delay or he risk of payoff, if an asse is over-priced (under-priced), which implies a low (high) rae of reurn. So, reurn accouns for compensaion for he risk of holding an asse. However, one quesion arose when scholars aemped o shed some lighs on how securiies are raded in he marke, ha is wheher he equilibrium price consisen wih he fundamenals would be achieved by he marke? Demsez (1968) suggesed ha rade may involve some cos, which could be explici or implici. And he referred o he implici cos as he coss conneced wih immediae execuion of rading. Trading in sock markes can someimes be fricional in he sense ha supply and demand may fail o mach. Under such circumsances somebody, mos probably he marke makers, have o offer liquidiy for immediae execuion of rading o ake place. The marke makers who supply his liquidiy mus be compensaed for he risk hey have aken by rading an 14

15 asse immediaely before is equilibrium price has been esablished. So, reurn, in his sense, also accouns for compensaion for he risk of rading an asse. Amihud and Mendelson (1986) carried ou an empirical sudy of rading cos and found a direc link beween securiies reurn and liquidiy measured by heir bid-ask spread. Since hen, he empirical relaionships beween reurn and liquidiy have been well documened. The purpose of his hesis is o consider a paricular seing where an idenical securiy (e.g. American Deposiory Receip (ADR)) is raded in muliple markes, and o sudy why an ADR and is idenical underlying share are no guaraneed o be raded a he same price in hos and home markes. An American Deposiory Receip (ADR) represens he ownership in he shares of a foreign company rading on he US financial markes and subjeced o commission fees, an ADR is possible o be convered ino is underlying shares or vice verse. ADR and is underlying share are in principle idenical securiy, however in pracice hese are somehow raded a differen prices across markes. In his hesis, we aim o answer hese following quesions. Firs of all, we consider he quesion wheher or no he Law of One Price exiss (he Law hereafer). The Law saes ha if wo asses have he same payoffs (in every sae of naure), hen given he weak form of efficien markes, hey mus rade a he same price. And he Law relaes o he impac of marke arbirage on he prices of idenical asses exchanged in wo or more markes. A deviaion from his Law would give rise o an arbirage opporuniy, as long as he price differenial exceeds all relaed ransacion coss. However, in pracice, he arbirage aciviy across muli-markes is subjec o he marke segmenaion. When wo markes are segmened wih each oher by imposing differen ax rae, having resricions on foreign ownership and currency, and employing asynchronous rading 15

16 hours, he arbirageurs have difficulies o promply remove price differenials. So he invesigaion of he Law in muliple markes would address addiional quesions relaed wih inernaional financial markes segmenaion. Therefore, inegraion vs. segmenaion is he nex concern for his sudy, because he linkage beween he markes will affec capial flow and informaion ransmission, and in urn, he arbirage opporuniy. A segmened marke is defined in finance as a marke where free labor, capial and informaion flows are resriced, for example, foreign currency conrols and foreign ownership limis. In addiion, in cross marke rading, a segmened marke also refers o a marke wih lile or no overlapping rading hours wih is counerpar. Usually, more rades are execued during he overlapping rading hours; as a resul, a lower liquidiy premium and higher volailiy are observed in boh markes. Third, we consider he quesion wha is he marke liquidiy effec in muliple marke rading. I is clear how liquidiy as a cos is priced in a single marke, ye how he liquidiy effec varies across markes is sill unclear. The explanaions may come from differen rading mechanisms and marke microsrucures which provide differen liquidiy risks and ransacion coss, as well as from differen price sabilizaion policies which affec volailiies. Finally, a beer undersanding on he relaion beween reurn volailiy and rading volume in dual markes rading is helpful in exploring how informaion flow affecs rading differenly across markes. Exchange occurs when marke agens assign differen values o an asse (Karpoff, 1986). Trading volume herefore is viewed as a variable which conains rading informaion, and raders in urn would revise heir demand prices based on he observed rading volume daa. As a resul, reurn volailiy 16

17 is higher when rading is more acive. The Chinese American Deposiory Receips offer a unique opporuniy o invesigae all he quesions menioned above. In addiion, heir disincive characerisic makes his sudy an imporan conribuion o he lieraure of he ADRs. Unlike he ADRs from oher developed and emerging counries which are usually in he framework of wo relaed markes, he Chinese ADRs involve hree relaed markes due o he fac ha a par of hese Chinese firms lised A shares (exclusively owned and raded by he Chinese ciizens in mainland China) in Shanghai afer hey sequenially lised ADRs in he US and H shares in Hong Kong (he ADRs and H shares are exclusively owned and raded by foreign invesors). The A shares lising makes China s domesic sock marke as one of imporan facors when we invesigae he marke segmenaion. And wo addiional ineresing concerns arose, firs, A shares lisings would increase shareholders base of hese lised firms, and leads o he decrease in he reurns of he ADRs and H shares. This suspec is based on he Invesors Recogniion Hypohesis by Meron (1987), who argued ha expeced reurn of he firm s sock decrease wih he size of he invesor s shareholder base. Second, we suspec ha for he Chinese ADRs wih A shares lised in Shanghai, he price differenials beween he Chinese ADRs and he underlying H shares will be affeced by China s domesic sock marke as well, because of he close geopoliical relaion beween China and Hong Kong in erms of overlapping rading hours, common culure and business aciviies. Apar from he special characerisic we have menioned above, we noice ha he NYSE lised Chinese ADRs are exclusively sae owned enerprises (SOEs), while hose lised in he NASDAQ are all privae firms. This obvious difference in cross-lising 17

18 locaions suggess ha he ownership srucure of hese Chinese firms may conribue o undersand he price behaviour of hese Chinese ADRs. Furher, he SOEs lised in he NYSE are enerprises wih monopoly power in some imporan indusries, such as uiliy, elecronic communicaion, and oil and gas. Then one more quesion arose ha why he Chinese governmen wan o lis hese imporan companies abroad. Since he convenional perspecive is he Chinese governmen would like o enirely conrol he SOEs. We herefore sar our research from he origin place of he Chinese ADRs: China s domesic sock marke. Chaper 2 provides an ouline and analysis of China s sock marke liberalizaion and he marke microsrucures of he wo domesic sock exchanges in China and he sock exchange in Hong Kong. There are wo reasons why we presen his survey of he domesic China s sock marke before we proceed o he empirical research on he Chinese ADRs arbirage. Firs, as we have menioned before, par of he Chinese ADRs have addiional A shares lised in Shanghai, which akes he impac from China s sock marke ino accoun. Second, he Chinese ADRs include boh SOEs and privae firms, and hese wo ypes of firms have exremely differen lising paerns and lising locaions, which inspires us o ake a deeper examinaion on he ownership srucure of he Chinese lised firms. We will focus on he special characerisics of he Chinese lised firms, invesors, and sock exchange which are normally he hree componens of a sock marke. China s sock marke makes iself unique by imposing resricions on sae-owned and non-sae-owned shares of he lised firms; sae-owned shares are non-radable while non-sae-owned shares are radable. Furher, he invesors of he radable shares are 18

19 divided ino domesic ciizens and foreigners. Domesic invesors can only own A shares, while foreign invesors can eiher own H shares (lised in Hong Kong) or B shares (lised in mainland China). We will discuss he differen ypes of shares and segmened sub-markes in deail in chaper 2, and focus on he impac of hese resricions on he performance of he lised firms and he funcion of he markes. Some ineresing issues are invesigaed, such as wo-hirds non-radable sae-owned shares, and he price discoun puzzle. However, since China joined he WTO in 2002, China s domesic capial marke has been gradually opened up o foreign invesors, as well as relaxing conrols on domesic ciizens diversifying heir porfolios by invesing abroad. We will also give deailed inroducion on hese marke innovaions. Chaper 2 also examines he marke microsrucure and ransacion coss of he hree China-relaed sock exchanges: he Shanghai sock exchange, he Shenzhen sock exchange, and he sock exchange of Hong Kong. We provide an overview of he marke condiion of each marke, such as marke capializaion, he raio of marke capializaion o GDP, P/E raio, annual rading value, and annual urnover rading value. In paricular, for China s sock marke we also look a he marke capializaion of he radable shares which urns ou o be exremely small, while he raio of he oal rading value o he marke capializaion of he radable shares is exremely high. A comparison of marke mechanisms is also provided, which includes he dealer mechanism vs. he aucion mechanism; floor based rading vs. auomaed rading; clearing and selemen sysem; and marke maker sysem. We also repor he marke regulaions o conrol marke volailiy, and compare he explici and implici ransacion coss. Chaper 3 presens he reviews of he ADRs lieraure and he sudies of liquidiy. 19

20 We caegorize he exising papers abou ADRs ino hree issues, namely, firms moivaion for cross-lising, price discovery, and he ADRs arbirage. The firs issue is from he viewpoin of firms which explains he benefi of lising shares in overseas markes, especially for he firms from emerging markes o cross-lis in developed markes. The second issue, price discovery, is from he viewpoin of marke. Price discovery is defined as he search for an equilibrium price and is a cenral funcion of a sock exchange. For he ADRs, he research quesion is in which marke ha price discovery akes place, he hos or home marke? And wo relevan hypoheses will be addressed, segmened marke hypohesis and he cos of capial. The hird issue, he ADRs arbirage, is from he viewpoin of raders, he rading sraegies of informed raders and noise raders. In paricular, we will review he papers wih regard o wo quesions. Firs, does he arbirage possibiliy exis? Second, why arbirageurs do no exploi he price differenials of he ADRs? In his chaper, we also review he papers abou liquidiy effec on asse pricing. We focus on he differen measures of liquidiy, and emphasize o be aware of he differen concep beween liquidiy level and liquidiy risk. Chaper 4 conains empirical sudies on he Chinese ADRs arbirage. We follow he lieraure review in chaper 3 o develop our es hypoheses. We answer he firs quesion ha wheher he Law exiss beween he Chinese ADRs and heir underlying H shares. Since he findings abou he exising of he arbirage possibiliy in he ADRs are inconsisen, and we believe he differen findings are due o differen approaches ha used in hose papers. We hen apply he approaches of he papers which claim no arbirage possibiliy is found, as well as he approaches of he papers which find ha he 20

21 arbirage possibiliy may exis due o he differen reurn disribuions beween he ADRs and heir underlying shares. Our findings indicae ha alhough we can no rejec he Law exising in he Chinese ADRs by comparing mean and median of he wo securiies reurns, we sill find reurn disribuions are differen beween he Chinese ADRs and heir underlying H shares, especially differen in he ails. In addiion, we find ha he Chinese ADRs wih A shares lised in Shanghai are differen wih hose wihou A shares in erms of disribuions of reurn and reurn spread. We hen proceed o answer he second quesion why he arbirage aciviy is hampered by examining wo effecs, he comovemen effec and liquidiy effec. The comovemen effec is caused by he informaion based barriers beween wo segmened markes due o asynchronous noise rading in wo markes. The professional arbirageurs who are usually subjec o shor erm horizon face he risk o be agains he asynchronous noise raders. The comovemen effec suggess ha wih regard o he dual-lised shares, he sock s reurn will move wih is local marke reurn raher han wih he off-shore marke reurn. We find significan evidence for he conemporaneous and lagged comovemen effec on he Chinese ADRs and heir underlying H shares. Furher, we examine he liquidiy effec which is caused by rade based barriers beween wo segmened markes. The liquidiy effec suggess ha differen illiquidiy coss beween he hos and home marke may increase he risk for he arbirageurs o exploi arbirage profi. Chaper 2 has discussed he marke microsrucure and compared rading coss of he Hong Kong sock exchange and wo sock exchanges in mainland China, where applicable, we also compare he rading coss wih hose of he wo US sock exchanges. The difference in he marke microsrucure leads o differen illiquidiy 21

22 and liquidiy risk. Therefore, we employ wo proxies o measure illiquidiy and liquidiy risk respecively, and provide evidence for he liquidiy effec. Finally, we conduc a sub-period es o find ou wheher or no marke liberalizaion in China and marke collapse in he US have any impac on ADRs reurn spread. Two breaking poins are seleced, he years 2000 and 2003, he significan srucural changes are found around 2000, and a ime-varying marke impac from China and Hong Kong marke index is repored. Chaper 5 is o sudy he volume-volailiy relaion of he Chinese ADRs and heir underlying shares. This chaper is an exension of he sudy on liquidiy risk in chaper 4. As he lieraure suggess ha rading volume may conain rading informaion, and reurn volailiy increases when new informaion arrives a he marke. The process ha raders keep adjusing heir expeced prices upon new informaion arrival is viewed as an implicaion of volume-volailiy relaion. We firs find a proper approach o model reurn volailiy, and hen compare he volume-volailiy relaion of he Chinese ADRs and ha of heir underlying H shares. Our findings no only jusify he use of wo General Auoregressive Condiional Heeroskedasic (GARCH) models, bu also provide evidence ha he US and Hong Kong invesors respond o he bad news differenly, and his difference in he invesors sensaions may explain he differen reurn disribuions of wo securiies as we show in chaper 4. Our findings also provide evidence of he validiy of wo compeing heories in he volume-volailiy relaion; he Mixure of Disribuions Hypohesis (MDH) is no verified by our resuls, while he Sequenial Informaion Arrival Hypohesis (SIAH) is suppored. Finally, in chaper 6, we provide he conclusion of he new findings and 22

23 limiaions of his hesis. This sudy makes imporan conribuion o he lieraure in several areas. Firs, in chaper 2, we give a compleed sysemaic invesigaion on he hree China-relaed sock markes wih respec o rading mechanisms, marke microsrucure, ransacion coss, and volailiy conrol policies, o our bes knowledge, no published papers on his area have involved all hese hree markes, and all daa and informaion we provide in his hesis are up-o-dae, which is by he end of Second, in chaper 4, we poin ou ha he sandard locaion ess, such as -es and Wilcoxon ranked es, are no enough o convince ha no arbirage possibiliy exiss in he ADRs. For he cross-lised securiies, he difference in reurn disribuions may provide arbirage possibiliy even hough hese wo securiies are equal in he mean of heir reurns. We make complemen o he lieraure of he comovemen effec on he ADRs arbirage ha no only he conemporaneous bu also he lagged marke reurn has impac on he securiies raded in here. We also provide supporive evidence o he argumen by Kim e al (2000) ha he US invesors are over-reacing he US marke shocks, since we have showed ha he lagged marke impac from he US is significanly negaive. Furher, we find obvious difference in he Chinese ADRs wihou A shares and hose wih A shares. The average reurns of he ADRs wihou A shares are higher han hose wih A shares, his finding jusify he Invesor s Recogniion Hypohesis ha he increase in he shareholders base will decrease expeced reurn of he socks. In addiion, we find he magniude of he comovemen effec of he Chinese ADRs wihou A shares is bigger han hose wih A shares. This may sugges ha he Chinese ADRs wihou A 23

24 shares move more closely wih he local marke han hose wih A shares. Third, in chaper 5, we employ wo GARCH models o examine leverage effec, which reflecs invesors sensaion o good news and bad news. We no only make conribues o he lieraure of he ADRs arbirage ha differen reurn disribuions beween he ADRs and underlying shares could be caused by heerogeneous invesors sensaion o bad news. We also give supporive evidence for he recenly developed hypohesis of Invesors Senimen in behaviour finance, which suggess sock price is a funcion of invesors senimen. 24

25 Chaper 2 A Survey of China s Sock Marke 2.1 Inroducion China s experience wih is securiies markes exends back o 1891 when foreign brokers founded he Shanghai Sharebrokers Associaion, which was headquarered in Shanghai as China's firs sock exchange. In 1904 he Associaion applied for regisraion in Hong Kong and i was renamed as he Shanghai Sock Exchange. By he 1930s, Shanghai had emerged as he financial cenre of he Far Eas, where boh he Chinese and foreign invesors could rade socks, debenures, governmen bonds, and fuures; he Shanghai Sock Exchange grew o be he larges domesic securiies exchange wih 140 lised companies. The operaion of Shanghai Sock Exchange paused in 1941 because of he World War II, and re-opened in 1946, bu closed again since 1949 when he Communis revoluion ook place (Lavelle, 2004). The milesone in he developmen of China s sock marke is he esablishmen of he Shanghai Sock Exchange and he Shenzhen Sock Exchange in he early 1990s, before ha, he Chinese governmen had done some experimens in Shanghai and Shenzhen by seing up Over-The-Couner (OTC) markes where only small-scale rading of reasury securiies and shares were processed, and he securiy prices on he OTC markes were deermined by negoiaion beween buyers and sellers, insead of on he basis of aucion. By he end of 2006, here were a oal of 1434 lised firms, and he oal marke capializaion is RMB 8,940.4 billion (US$ billion) in boh sock exchanges, and among hem, Shanghai Sock Exchange accouns for RMB 7,161.9 billion 25

26 (US$ billion). A large number of books, research papers and repors abou China s sock marke have given us valuable insighs ino he developmen and working of China s sock marke. Green (2003) and Waler and Howie (2003) have provided a deailed coverage of he hisory of China s equiy marke and sae owned enerprises (SOEs) reform from mid 1980s o early 2000s, righ before he ownership srucure reformaion of China s sock marke. In his survey paper, we ry o presen a picure of he uniqueness of he Chinese sock marke hrough invesigaing he hree componens of he marke. Sock exchange, lised firms, and he shareholders are he hree necessary componens which make up a convenional sock marke and his is also he case for China s sock marke. However, almos each of hese hree componens has unparalleled feaures in China which makes he Chinese marke unique. In secion 2.2, we sar by looking a he lised firms wih focusing on heir ownership and shareholder srucure. China is a counry wihou any hisory or radiion of privae propery righs since 1949, and, herefore, is experiencing a process of ongoing ransiion from a highly cenrally planned economy o a marke economy a presen; and in addiion, a counry which is more or less sill governed according o he socialis ideology inheried from he Maois period. In China s sock marke, he lised companies issue wo-hirds non-radable shares which are conrolled by he sae and he invesors have a limied choice o decide he ype of shares hey can buy, even hough he sock exchanges have adoped one of he mos advanced elecronic rading sysems in he world. 26

27 The Chinese lised firms differ from he lised firms in oher developed or emerging sock markes no because hey are sae owned enerprises (SOEs) bu because around wo-hirds of non-radable shares issued by he lised firms are ulimaely conrolled by he sae, while only he one-hird of shares can be raded in he sock marke. Alhough he Chinese auhoriies arranged o make one-hird of shareholdings of he lised SOEs available o privae invesors, his parial privaizaion wihou changing he lised firms conrol righs has been found o be he main reason behind he failure in improving he performance and corporae governance of he lised SOEs in he lieraure (Groves e al., (1994); Gao, (1996); Cao e al., (1999); Allen e al., (2005)). The wo-hirds ownership of non-radable shares by he sae has no only hindered he performance of he Chinese lised SOEs bu has also become a criical blockage o a healhy progress of China s sock marke. I has also brough a number of oher problems; from he early 2000s, he Chinese auhoriies have made several aemps o deal wih he problem of non-radable shares on several occasions. However, all hese aemps ended up in failures, unil April 29, 2005, when he China Securiies Regulaory Commission (CSRC) announced a new pilo program, inviing a firs bach of four sae owned companies o ransform heir non-radable shares ino radable shares by compensaing he exising shareholders in various ways like bonus shares, cash, and opions. The main difference of his policy from he previous aemps is ha he new reform allowed he radable shareholders o bargain over he ransfer of non-radable shares. Such flexibiliy seemed o be working well. Among hese four companies, only one firm failed. On June 2005, he CSRC iniiaed he second pilo program involving 42 companies worh 10% of overall sock marke value. On Augus , his second 27

28 program was successfully accomplished. We leave he deailed discussion abou he lised companies ownership srucure and he reformaion in secion 2.2. In secion 2.3, we shed lighs on he segmened naure of he sock marke wih regards o shareholders, which includes hree sub-markes, A share marke for domesic shareholders, B and H share marke for foreign shareholders. The problem along wih he segmened marke is price puzzle, for example, he invesors in one sub-marke have o pay higher (lower) prices han he invesors in oher sub-markes, and his raises he quesion: wha is he rue value of a lised firm? Mos researches reveal ha his price puzzle is due o he arificial barriers se up by he Chinese auhoriy. However, China s sock marke has been making progress sep-by-sep o break down he barriers. On February 19, 2001; he China Securiies Regulaory Commission (CSRC) announced ha he Chinese residens would be allowed o own B shares, which are shares of mainland companies and raded in boh he Shanghai and Shenzhen sock exchanges and denominaed in US$ (Shanghai sock exchange) and HK$ (Shenzhen sock exchange). Furher, on November 5, 2002 he CSRC and he People's Bank of China (PBOC) inroduced he QFII (Qualified Foreign Insiuional Invesor) program as a provision for foreign capial o access China's financial markes. On 13 April 2006 he Chinese auhoriies launched QDII (Qualified Domesic Insiuional Invesors), a scheme under which seleced governmen auhorized domesic insiuional invesors are allowed o inves in overseas capial markes under he foreign exchange conrol sysem in China. However, ill now his faciliy is resriced o invesmen in he capial marke of Hong Kong only (Nefici e al., 2007; informaion can be also found in he official websie: hp:// 28

29 These policies have parially released price discoun puzzle, for example, par of B share discoun declined afer February 19, 2001, on he oher hand, QFII and QDII are wih limied applicaion by insiuional invesors, a horough inegraion of hree sub-markes, as ye, remains incomplee. In secion 2.4, we look a he sock exchanges by focusing on he marke microsrucure, and compare i wih he Hong Kong sock exchange where H shares are raded. We provide an overview of he marke condiion of each marke, such as marke capializaion, he raio of marke capializaion o GDP, P/E raio, annual rading value, and annual urnover rading value. Paricularly, for China s sock marke we also look a he marke capializaion of he radable shares which urns ou o be exremely small, while he raio of he oal rading value o he marke capializaion of he radable shares is exremely high. We compare he differen marke mechanisms, which include dealer mechanism vs. aucion mechanism; floor based rading vs. auomaed rading; clearing and selemen sysem; and marke maker sysem. We also repor he marke regulaions o conrol marke volailiy, and ransacion coss. 2.2 The Chinese Lised Companies, Impac of Ownership Srucure on China s Sock Marke A Brief Hisory of China s Sock marke Beginning in he lae 1980s, enerprise reforms ook place during China s gradual ransiion o a marke economy; many SOEs and collecive enerprises issued shares o 29

30 heir employees in order o save on wage expenses. Local governmens in China sared experimening wih selling shares of collecively owned enerprises direcly o privae individuals in order o raise equiy capial. Privae propery righs, as well as he erm propery righs, was reinroduced in he sphere of share holdings by law for he firs ime since is aboliion in China in 1949, when he Chinese Communis Pary inroduced socialism in China. However, sill in he spiri of he socialis ideology and cenrally planned economy, he policies were designed o improve he performance of sae owned firms raher han ourigh ransfer of heir ownership o he privae secor. Two over-he-couner (OTC) markes were launched; one was in Shanghai in 1984 and he oher was in Shenzhen in 1986, here were only a handful of shares rading in hese informal exchanges. Neverheless, funding raised in his way proved o be vasly insufficien for he SOEs in heir process of ransferring from a planned o a marke based insiuions, so in he lae 1990s and early 1991s, wo sock exchanges, creaed respecively by he Shanghai municipal governmen and he Shenzhen municipal governmen, were esablished, wih he cenral governmen s formal approval. Table 2.1 Chronology of he hisorical evens of he China s sock marke 1891 Shanghai Sock Exchange founded o broker foreign socks 1905 Shanghai People s Exchange founded in Hong Kong 1914 Shanghai Sock Commercial Associaion founded: China s firs formal sock rading associaion; Norhern Governmen issues Sock Exchange Law December Shenzhen begins rial operaions wihou formal approval and wih only 1,1990 December 19,1990 one sock rading Shanghai Sock Exchange begins operaions. PBOC announces ha all public sock issues and lisings can only be done on he Shanghai and Shenzhen exchanges: opens he primary marke again July 3, 1991 Shenzhen Sock Exchange is formally approved and opened afer seven monhs of rial operaion 30

31 Ocober 7, Brilliance China Auomoive liss on he NYSE, raising US$80 million This was China s firs ever overseas IPO Ocober 25, CSRC esablished; shorly afer announces nine candidaes companies for 1992 Hong Kong lising, known as he Firs Bach July 29, Tsingdao Beer complees he firs SEHK IPO by a Chinese company, 1993 raising US$115 million December Naional People s Congress passes he Company Law 29, 1993 July 1, 1994 Zhu Rongji signs Company Law ino effec permiing Shandong Huaneng (HNP laer) o proceed wih is NYSE lising, he firs direc lising of a Chinese company on he NYSE Augus 10, 1994 Firs direc lising of a Chinese company on he NYSE, Shandong Huaneng Power Generaion, raising US$333 million July 1, 1997 Hong Kong reurns o Chinese sovereigny December Naional People s Congress a las passes Securiies Law 29, 1997 July 1, 1999 Securiies Law goes ino effec; CSRC begins preparing regional offices ha would give i a naional presence for firs ime Ocober 27, Sale of sae shares hrough inclusion in public offerings announced 1999 March 14, The CSRC approves lising and rading of lefover righs offering shares 2000 (zhuanpeigu) beginning in April. A sar o geing rid of residual March 17, 2000 February 19, 2001 November 5, 2002 April 13, 2006 non-radable shares To comply wih he Securiies Law, CSRC releases regulaions defining he new review mehod (hezhunzhi) for lising applicaions, and eliminaes old quoa and adminisraive pricing mechanisms Domesic invesors permied o buy B shares The CSRC and he People's Bank of China (PBOC) inroduced he QFII (Qualified Foreign Insiuional Invesor) program as a provision for foreign capial o access China's financial markes. The CSRC and he People's Bank of China (PBOC) inroduced he QDII (Qualified Domesic Insiuional Invesors), which allows seleced governmen auhorized domesic insiuional invesors o inves in overseas capial markes under he foreign exchange conrol sysem in China. Source: Waler and Howie, The Feaures of China s Sock marke China s sock marke remains a hybrid wih planned and marke-oriened componens; since is iniiaion, i has formulaed paricular rules which are clearly differen from hose 31

32 of he convenional sock markes. Normally, a sock marke consiss of he sock exchange, lised firms and shareholders, and he foundaion of his framework is an eniy of privae propery wih legal proecion. I is difficul o imagine ha in a counry such as China wih a fairly shor experience of privae ownership, securiies and sock exchanges could ruly exis and funcion as well as he esablished convenional sock exchanges. On he oher hand, while he criical role ha a sock marke is supposed o play is o mobilize and allocae capial resource in a marke economy; he primary moivaion for developing China s sock marke was o mobilize privae funds in order o finance SOEs as well as o improve SOEs performance hrough public paricipaion. An efficien sock marke should possess he abiliy o allocae capial ino he mos producive secors as soon as possible; in conras, China s sock marke apparenly favours SOEs alone wihou any consideraions of heir performance. Incorporaion and lising of a minoriy of sakes of SOEs hrough IPOs is no an aciviy which is unique o China. Berkman, e al. (2002) showed ha he median offering of IPOs was only 35% of a firm s equiy capial based on a worldwide sample of 384 SOEs share-issue during Bu, China is raher unique in creaing such a rigid se of share ypes, placing resricions on he rading and ownership of each. In mos developed or emerging sock markes, he common shares issued by companies give specific righs o heir owners, primarily he righ o voe a shareholders meeings, o receive companies profis in he form of dividends and o sell he shares in he secondary marke if he owner so wishes. All owners of common shares enjoy hese righs and are reaed equally under mos circumsances. In conras, alhough China has arificially creaed hree caegories of individual, 32

33 legal person and sae shares and awarded all of hem exacly he equal righs by law, legal person and sae shares which accouned for around wo-hirds of he oal ousanding shares of lised firms were declared non-radable. However, as we will see laer, following he reform, which sared in 2005, his siuaion has changed considerably. Individual shares, in China, are he only sor of shares ha can be lised and publicly raded on he sock exchanges, owned by reail invesors or employees of a company who have invesed heir own wealh in he company. Sae shares are issued o auhorized governmen organs acing on behalf of he sae in reurn injecion of asses such as buildings, equipmens, and land-use righs. Sae shares are owned ulimaely by he Sae Council and are currenly managed by he Sae-owned Asses Supervision and Adminisraion Commission of he Sae Council (SASAC) and local sae asse managemen bureaux. Legal Person (LP) shares are creaed hrough he injecion of asses from legal person eniies, which include enerprises, insiuions or auhorized social groups. The LP shareholders could be sae LP shares if he legal person eniies are sae-conrolled. In conras, a company may also issue LP shares o non-sae invesors who conribue non-sae asses and hese shares become sandard LP shares. Furhermore, he Chinese governmen has segmened he marke in erms of shareholders ino five; marke for domesic A share invesors, marke for foreign B share invesors, marke for foreign H share invesors, marke for legal person shares, and finally a marke for sae shares. The lised firms have differen marke prices in each marke, arbirage among five markes is nearly forbidden. For example, for he firms issuing A 33

34 share and H share, alhough H shares has been raded a discoun ranging from 50% o 90% of heir respecive A share (Waler and Howie, 2003:179), here is no way or arbirage mechanism o shor A shares and buy H shares, because due o he resricions on foreign exchange currency he Chinese ciizens can only purchase very limied amoun of foreign currency. On he oher hand, no convenional sock markes exis in China for he ransfer of LP and sae shares. LP shares used o be ransferred hrough managemen buy-ou (MBO), and he shares were usually priced below ne asse value (NAV), and far lower han A share s price (Waler and Howie, 2003:185). Chen and Chen (2007) discussed he undervaluaion scandals along wih MBO ransacions, such as he unfairness revealed in MBO due o share mispricing, illegal sources of funding, and lack of ransparency. As a resul, MBO has been almos sopped since 2004 by he Chinese auhoriies, since hen ransferring LP shares has been carried ou mainly hrough Mergers & Acquisiion (M&A). Sae shares were ransferred only among sae eniies a negoiable prices before non-radable sae-owned shares reform. A disinc feaure of ownership srucures of he Chinese lised firms is he holders of non-radable shares have exacly he same voing and cash flow righs as he holders of radable shares; where, as we have menioned before, hese non-radable shares canno be raded publicly even hough he company is publicly lised. Typically hese shares belong o he sae or o domesic financial insiuions which are ulimaely owned by he cenral or local governmens. In oher words, individual radable shareholders bear marke risk while non-radable shareholders do no, bu hey enjoy he same righs. Furhermore, individual owners are discriminaed agains in erms of pricing, because hey pay a higher price for heir shares han non-radable shareholders who are allocaed 34

35 heir shareholdings prior o he IPO a price close o ne asse value, which is far less han he IPO price. By he end of 2002, only 6% of lised companies had non-radable shares accouning for less han 40% of oal equiy capial, while only 0.4% of lised companies had no non-radable shares a all (Green, 2004) Non-radable Shares Ownership Problems i. Problem of asse-sripping The direc consequence of he wo-hirds non-radable shares ownership srucure leaves he marke in a posiion o be manipulaed by he insiuional invesors and local governmens. The insiuional sae shareholders could easily make asse-sripping via cash dividend which is a regular way o pay ou company profis. As repored by Green (2004), before April 30, 2003, 657 ou of 1,236 lised companies declared eiher a cash or sock dividend. Among hem, 622 lised firms paid a oal cash dividends amouning o RMB 45.8 billion (US$ 5.5 billion), which is around 53% of hese companies oal ne profis. Reail A share invesors suffer because LP shareholders pay subsanially less for heir shares han hey do. I is herefore LP shareholders ha predominanly benefi from cash dividends since all shareholders receive he same dividend. Of he RMB 45.8 billion (US$ 5.5 billion) worh of dividends announced by April 2003, he holders of raded shares received only RMB 16 billion (US$ 1.9 billion), he res going o insiuional sae shareholders (Green, 2004). 35

36 ii. Problem of performance deerioraion afer lising The vas majoriy of researches on he quesion ha wheher he Chinese SOEs performances have improved or deerioraed afer lising in he sock marke have failed o record any evidence of improvemens. Allen e al. (2005) concluded, afer a deailed analysis of naional economic saisics, ha i is he privae non-lised secor of he economy ha has driven China s economic growh. They argued ha poor governance has consrained he performance of lised firms. Wang e al. (2001) invesigaed he impac of lising of firms wih A shares; hey documened ha company performance declined significanly afer lising. Chen e al. (2002) found ha firm performances generally deerioraed boh in erms of profiabiliy and efficiency afer lising. They showed reurn of equiy and earnings per share generally declined during he 1990s; he only excepions are he firms in he public uiliies, ranspor and finance secors. Huang and Song (2002) showed ha even lising in Hong Kong sock exchange had no posiive effecs on performance improvemens; which is in conradicion o general expecaions ha foreign ownership helps o improve firm performance. iii. Problem of sock marke speculaion The large proporion of non-radable equiy means ha he share of socks which are acually raded in he Chinese sock marke is relaively small (see able 2.2). This is very small in comparison o maure markes, such as UK, US, and Hong Kong; hese markes have marke capializaion of over 110% of he free floa/ GDP raios. The exremely low 36