Information Asymmetry, Market Segmentation and the Pricing of Cross-listed Shares: Theory and Evidence from Chinese A and B Shares

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1 Informtion Asymmetry, Mrket Segmenttion nd the Pricing of Cross-listed Shres: Theory nd Evidence from Chinese A nd B Shres Sugto Chkrvrty Purdue University West Lfyette, IN Asni Srkr 1 Federl Reserve Bnk of New York New York, NY Lifn Wu Deprtment of Finnce nd Lw Cliforni Stte University, Los Angeles Los Angeles, CA 9003 Previous version: Jnury 1998 This version: July 1998 ABSTRACT JEL Clssifiction numers G1, G14, G15 In contrst to most other countries, Chinese foreign clss B shres trde t n verge discount of out 60 percent to the prices t which domestic A shres trde. We rgue tht one reson for the lrge price discount of B shres is ecuse foreign investors hve less informtion on Chinese stocks thn domestic investors. We develop model, incorporting oth informtionl symmetry nd mrket segmenttion, nd derive reltive pricing eqution for A shres nd B shres. We show theoreticlly tht n A shre index security, trdle y foreigners, increses the liquidity of B shres. Our empiricl study of Chinese stocks supports the predictions of our model. Specificlly, we show tht our model-sed proxies for informtionl symmetry explin significnt portion of the cross-sectionl vrition of the B shre discounts. 1 Reserch Deprtment, 33 Lierty Street, New York, NY Telephone , fx , e -mil ASANI.SARKAR@NY.FRB.ORG. We grtefully cknowledge the comments of n nonymous referee, Stephen Brown, Jen Helwege nd Jy Ritter. All mistkes re ours lone. The views here re those of the uthors nd do not necessrily reflect the views of the Federl Reserve Bnk of New York or the Federl Reserve System

2 I. INTRODUCTION The finnce literture hs, in recent yers, documented mny cses where foreign clss shres i.e., shres offered to foreign investors trde t premium reltive to domestic shres Hietl, 1989; Bergstrom, Rydqvist nd Sellin, 1993; Biley nd Jgtini, 1994; Stulz nd Wsserfllen, However, the reverse cse---where foreign shres trde t price discount reltive to domestic shres---hs received less ttention. An exmple is the Chinese stock mrket, where domestic investors cn only trde A locl shres, while foreign investors re restricted to trding B foreign shres. 3 Although the two shre clsses re identicl with respect to shreholder rights, such s voting nd profit shring rights, foreign investors py only smll frction of the prices tht locl investors py for identicl stocks Biley, 1994; Wo, 1997; Chen nd Su, In this pper, we exmine, oth theoreticlly nd empiriclly, the pricing of dul listed Chinese stocks. Consistent with the previous literture, we find tht B shres trde t sustntil discount reltive to A shres. Specificlly, the dily men nd medin price discounts for the B shres in our smple, for the period Jnury 1994 to Decemer 1996, re percent nd percent, respectively. We rgue tht the discount exists ecuse foreign investors hve less informtion out locl firms, reltive to domestic investors. We develop theoreticl model, incorporting oth symmetric informtion nd mrket segmenttion, nd For exmple, Hietl 1989 investigtes the price premi for Finnish stock mrket for the period nd reports monthly men premium of 30% for the foreign shre price. Bergstrom, Rydqvist nd Sellin 1993 show price premi of foreign shres rnging from 5% to 68% for 196 firms listed on the Stockholm Stock Exchnge during the period Biley nd Jgtini 1994 document n verge premium of 19% on the Alien Bord of the Stock Exchnge of Thilnd. Stulz nd Wsserfllen 1995 find foreign investors py higher prices for shres thn domestic investors for smple of 19 firms listed in Switzerlnd. 1

3 derive reltive pricing formul for A nd B shres. In the theoreticl model, we lso explore the effect of introducing index securities on the liquidity of the B shre mrket. In our empiricl tests, we construct proxy for informtionl symmetry, nd provide evidence in support of our theoreticl predictions. Why do foreign shres trde t such lrge discounts in Chin, nd t premium in other mrkets? Mny of the usul explntions for price differences etween domestic nd foreign shres do not pper to e importnt for Chin. Foreign investors fce low rriers to trding B shres, reltive to domestic investors trding A shres. There is no time lg in trding etween the domestic nd the foreign shres; nd neither dividends nor cpitl gins re txed in Chin. Incomplete diversifiction on the prt of domestic investors nd foreign ownership restrictions re more likely to led to price premi rther thn discount for the B shres. 4 We rgue tht foreign investors find it more difficult to cquire nd ssess informtion out locl Chinese firms, reltive to domestic investors. These difficulties re due to lnguge rriers, different ccounting stndrds, nd lck of relile informtion out the locl economy nd firms Kye nd Cheng, 199; Sze, Mny listed B shre firms do not fully nd promptly disclose ll mteril chnges in their usiness conditions, nd pulished sttements re not lwys prepred ccording to interntionl ccounting stndrds. While these prolems fce 3 As Wo 1997 points out, the Chinese equity mrkets re the only equity mrkets covered y the Interntionl Finnce Corportion tht completely restrict cross-clss trding. 4 Eun nd Jnkirmnn 1986 nd Alexnder, Eun nd Jnkirmnn 1987 develop model of interntionl sset pricing in the presence of the foreign ownership restrictions on the domestic shres. They show tht foreign investors offer premium to domestic investors when the ownership constrint is inding. Hietl 1989 points out tht domestic investors cnnot diversify wy the specific country risk s effectively s foreign investors cn.

4 ll investors, they re worse for foreign investors since locl investors my e le to tp informl locl informtion sources tht re unville to nonresident investors. 5 While informtion symmetries my e present in other countries, they re prticulrly relevnt for Chin. For one thing, unlike countries such s Finlnd, Sweden nd Switzerlnd, where foreign shres trde t premium, Chin is n emerging stock mrket. In fct, Chin hd no stock mrkets till 1990, nd B shres were not trded till 199. In common with other emerging mrkets, Chinese stock exchnges lck certin fetures tht could otherwise mitigte informtion symmetry for foreigners. For exmple, rel-time mrket informtion nd B shre prices re not ville nd Chinese mngers do not recognize the importnce of disclosure Sze, Further, shre mnipultion nd insider trding re considered to e rmpnt nd investor protections rights re not leglly codified Kye nd Cheng, 199. While the severity of these prolems my hve declined over time, they continue to e relevnt. As indirect evidence in fvor of the informtion symmetry hypothesis, we note tht, in our smple, the men dily price discount for the B shres listed on the Shnghi exchnge is 65.6 percent, compred to percent for B shres trding on Shenzhen. One interprettion for this difference is tht there is less informtion ville out Shnghi-listed firms. The Shnghi exchnge is dominted y former Stte-owned enterprises, wheres the Shenzhen mrket fetures more joint venture compnies, mny involving Hong Kong Chinese investors. As Sze 1993 points out, the former Stte-owned enterprises re most likely to suffer from poor ccounting nd disclosure stndrds, wheres mny joint venture compnies re mnged y the Hong Kong prtners. 5 For description of informl sources of informtion for locl investors, see Stock Mrket Mni is Sweeping Chin; Specultors Aound, in the Wll Sreet Journl, pge A1, August 7,

5 We derive simple sset pricing model, sed on Grossmn nd Stiglitz 1980, tht incorportes oth symmetric informtion nd mrket segmenttion in noisy rtionl expecttions frmework. Domestic investors trde A shres only, nd hve privte informtion out the future returns of the domestic stock. Foreign investors trde B shres nd foreign stocks, ut do not hve ny specil informtion out the domestic stock. However, foreign investors oserve the current price of A shres, which is informtive of oth A nd B shre returns. Hence, the A nd B shre mrkets re linked in informtion, lthough they re segmented in trding. Bsed on our model, we derive reltionship etween the prices of A nd B shres tht depends on oth the degree of symmetric informtion nd foreign investors diversifiction enefits since the B shre mrket expnds foreign investors opportunity sets. When there is no symmetric informtion, our model predicts premium for foreign B shres, s in previous models of mrket segmenttion. With severe symmetric informtion, however, B shres my trde t discount reltive to A shres. The degree of informtion symmetry is negtively relted to the covrince of the returns etween B nd A shres, nd positively relted to the vrince of B shre returns. We extend the model to llow for the possiility of n index security sed on the B shres. 6 Sze 1993 reports tht foreign investors recommend such B shre index to enhnce the liquidity of the B shre mrket. Surhmnym 1991, nd Gorton nd Penncchi 1993 show tht uninformed trders cn reduce their losses to informed trders y trding n index security, or sket of securities. We show, however, tht the introduction of B shre index does not ffect investors demnd for shres, nor the prices of A nd B shres. The reson is 4

6 tht, since A nd B shre mrkets re segmented in trding, the B shre index does not chnge the degree of informtionl symmetry etween domestic nd foreign investors. As n lterntive, we propose n index security of A shres tht cn e trded y foreign investors lthough the individul A shres re still restricted to domestic investors. We show tht introduction of the A shre index increses trding volume nd decreses the price discount in the B shre mrket. In our empiricl study, we use smple of 39 dully listed firms on the Shnghi nd Shenzhen stock exchnges to test the reltionship etween informtion symmetry nd the price discount on the B shres. We use the coverge of Chinese compnies in the English press s n inverse mesure of informtion symmetry, since firms with wider coverge in the medi my e esier to monitor. We find preliminry evidence consistent with the symmetric informtion hypothesis: the mgnitude of the B shre price discount is negtively relted to the numer of news reports in oth the Shnghi nd Shenzhen stock mrkets; nd, second, there re more stocks for which the A shre returns led the B shre returns, thn the other wy round. Next, we specify cross-sectionl regression, sed on our theoreticl model, to explin the determinnts of the B shre price discounts. We relte the discount to the covrince etween A shre nd B shre returns, the vrince of B shre returns, nd the medi coverge vrile---ll proxies for informtionl symmetry. We include the covrince etween B shre returns nd the S&P 500 index to mesure the diversifiction effect. We lso control for the reltive supplies of the A nd B shres nd the size i.e., mrket cpitliztion of the stock. The results re consistent with our theory. The medi coverge nd the B shre return vrince vriles re highly significnt, ut the diversifiction vrile is not. In ddition, firm size nd 6 We thnk the referee for suggesting this extension to us. 5

7 the reltive supply of A nd B shres re lso significnt. When we include n exchnge dummy, our specifiction explins 67 per cent of the cross-sectionl vrince of the B shre discounts. Other ppers hve lso studied the Chinese A nd B shre mrkets. Biley 1994 finds preliminry evidence for foreign shre discounts. Wo 1997 conducts ivrite Grnger cuslity test of A nd B shre returns nd finds evidence of two wy informtion flows etween the mrkets for his smple period Jnury 1993 to Octoer Chen nd Su 1998 find tht the A nd B shre mrkets re not perfectly integrted. They use the returns on the Chinese stock index s proxy for informtionl symmetry nd find tht it is positively relted to the difference in A shre nd B shre returns. However, the Chinese stock index return is more resonly interpreted s proxy for locl mrket risk, insted of informtionl symmetry. Further, since locl investors re more exposed to locl mrket risk, A shre returns re more sensitive to the locl index thn B shre returns. Unlike the current pper, none of the ove ppers test for informtionl symmetry sed on theoreticl model, nor do they construct direct empiricl proxies for informtionl symmetry such s our medi coverge vrile. In relted literture, Errunz nd Losq 1985 show tht securities inccessile to suset of investors require greter risk premi. Merton 1987 models limiting cse where investors only invest in suset of ville securities with which they re fmilir, ecuse of high costs of gthering nd processing dt. In recent pper, Stulz nd Wsserfllen 1995 demonstrte tht the dedweight costs including informtion costs for holding risky ssets differ cross investors nd cross countries, cusing demnd functions for domestic shres to differ etween domestic nd foreign investors. Brennn nd Co 1997 rgue tht while the 6

8 cse for informtion symmetry is wek for institutionl investors, there is little dout tht such symmetry exists for verge individul investor in different countries. The rest of the pper is orgnized s follows. Section II provides ckground informtion out A nd B shres. Section III derives pricing models for oth A shres nd B shres. Section IV presents empiricl evidence on the performnces of A nd B shres nd tests the model. Section V presents conclusions. II. STRUCTURE OF THE A AND B SHARE MARKETS Chin s two securities mrkets, the Shnghi Securities Exchnge SSE nd the Shenzhen Stock Exchnge SZE, were estlished in Novemer 1990 nd July 1991, respectively. The shres initilly listed on the SSE nd SZE were clled A shres nd could only e trded y Chinese citizens. Strting in erly 199, nother ctegory of shres, known s B shres, ws introduced exclusively for foreign investors. By the end of 1996, 514 compnies hd gone pulic, of which 87 firms were listed on the SSE nd the remining 7 firms were listed on the SZE. Of the 85 firms tht hve issued B shres, 4 re trded on the SSE nd 43 re trded on the SZE. The clss A shres re domestic ordinry shres denominted nd trded in Renmini i.e., the Chinese currency y Chinese citizens. The mjority of A shres re issued y Stteowned enterprises nd cn e clssified into three ctegories y type of ownership. 1 Stte shres, which re shres held y the government through designted government gency; Legl shres, which re shres held y the Chinese legl persons i.e., the enterprises nd/or other economic entities ut not individuls; nd 3 Pulic shres, which re shres owned y 7

9 ordinry Chinese citizens. According to the Chinese securities rules, only pulic shres cn e trded on the exchnges. Therefore these pulic shres re lso clled trdle shres. The Stte nd Legl shres re issued t the time the compny is formed, ut cnnot e trded. These specil regultions ensure tht the government mintins control over the listed compnies. 7 The clss B shres re specil Renmini-denominted ordinry shres offered to foreign investors, ut they re trded in foreign currency. Owners of B shres hve the sme rights nd er the sme oligtions s holders of A shres. B shres re trded for, nd their dividends pid in, foreign currency: US dollrs for the Shnghi B shres nd Hong Kong dollrs for the Shenzhen B shres. Individul investors re llowed to hold mximum of 5 percent of firm s B shres, ut totl foreign ownership through the B shre issues cnnot exceed 49 percent of firm s totl shres. The trding mechnism for B shres is similr to tht for the A shres. A shre orders re plced through locl rokers, nd B shre orders re sent to either locl or foreign rokers. All orders re executed through computerized tch system. Tle 1 descries the segmented stock mrkets in Chin. III. A MODEL OF PRICING CROSS-LISTED A AND B SHARES UNDER ASYMMETRIC INFORMATION AND MARKET SEGMENTATION In this section, we develop simple pricing model of A nd B shres, ssuming the two mrkets re segmented. The model is sed on Grossmn nd Stiglitz 1980, who introduce informtionl symmetries into noisy rtionl expecttion model of sset pricing. We modify 7 There is dete recently s to whether the Stte nd Legl shres should e llowed into the mrket. However, this relxtion is not likely to hppen in the ner future. 8

10 the model to llow for mrket segmenttion. The intuition ehind the model is explined most simply when there is one domestic A shre stock nd one foreign B shre stock. Lter, we llow multiple stocks nd the possiility of trding in index securities. There re two types of ssets: sfe sset with return r f nd two risky ssets---domestic nd foreign. Two clsses of shres re written on the domestic sset. Clss A shres re held exclusively y domestic investors, wheres clss B shres re held exclusively y foreign investors. In ddition, foreign investors hold purely foreign stock C, which cnnot e trded y domestic investors. The current mrket prices of these stocks p i, i=,,c, re known to ll investors. But, future prices re not known, nd hence u i, the end-of-period return of stock i, i=,,c corresponding to the A, B nd C clss shres, respectively is not known to the investors. Following Stulz nd Wsserfllen 1995, we ssume tht domestic investors hve dvntges in gthering nd processing informtion out the domestic sset, reltive to foreign investors. Since oth A nd B shres re written on the sme domestic sset, we formlly represent the future return process of the A nd B shres s follows: ~u = φ + ε 1 ~u = φ + γ where φ is the true return of the sset nd ε, γ re error terms. We ssume tht domestic investors oserve φ while foreigner investors cn only oserve the prices p, p nd p c. Below, we specify some properties of the rndom vriles. φ, ε nd γ hve trivrite norml distriution with vrinces Vrφ, Vrε, nd Vrγ, respectively. Also: 9

11 Eε = Eγ = 0 3 Eεφ = Eγφ = 0 4 E u ~ i φ=φ, Vr u ~ φ = σ ε, Vr u ~ *φ=vrγ 5 Given the informtion structure, nd the segmenttion etween A nd B shre mrkets, domestic investors demnds depend on φ nd p. Foreign investors demnds depend only on the stock prices p i, i=,,c. However, we ssume tht foreign investors hve rtionl expecttions; over time, they lern the reltionship etween the distriution of u nd the price p nd use this to cquire dditionl knowledge out the distriution of u since φ nd u re linked y. This knowledge is then used to derive the demnd for B shres. Let x i, i=,,c, represent the supply of shres in mrkets A, B, nd C, respectively. We ssume tht x i, i=,,c, is normlly distriuted with men Ex i, vrince Vrx i nd is independent of ll other rndom vriles in the model. Consistent with Grossmn nd Stiglitz 1980, we further ssume tht investors know the supply in their own mrket, ut not in mrkets where they re not trding. In prticulr, domestic investors know x ut foreign investors do not. Therefore, foreign investors cnnot infer φ perfectly from oserving the A shre price, since they cnnot distinguish etween vritions in price due to chnges in φ, nd vritions in price due to chnges in x. We denote price functions P i, i=,, c, to distinguish them from price reliztions p i, i=,, nd c. In equilirium, the price functions re determined so tht the demnd for shres in ech mrket equls the supply. For exmple, the domestic price function P x,φ will, in equilirium, e such tht the supply of A shres x equls n, the domestic investors demnd for 10

12 A shres. Note tht, since foreign investors do not know x or φ, they view P x,φ s rndom vrile P ~ x, φ. Summrizing, the informtion set of domestic investors is I = {φ, p, p, p c }, wheres the informtion set of foreign investors is I = {p, p, p c ; P * }, where P *.,. is some prticulr price function of x,φ determined in the A shre mrket see elow for further detils. We ssume the usul regulrities: there re no trnsction costs; ll ssets re infinitely divisile; nd trding is competitive in the A shre nd B shre mrkets. We lso ssume tht domestic nd foreign investors hve the sme degree of risk version nd the sme risk-free return r f nd tht their utility functions re exponentil, i.e., u ~ w ~ R e w1 i 1 i = 6 where R is the coefficient of constnt solute risk-version nd w 1i is the end-of-period welth of investor i, i= domestic, foreign. Since w 1i is normlly distriuted, this implies tht investors trde solely on the sis of the expected vlue nd vrince of their welth, conditionl on their informtion set I i, i =,. A. The Reltive Pricing Model With No Index Security In this section, we ssume tht there is just one stock trded in ech mrket. Hence, there re no index securities. An investor of type i, i =,, chooses the numer of shres of the risk-free sset M i nd the numer of shres of the risky sset n i to mximize the expected utility of his end-of-period welth, conditionl on his informtion set I i nd suject to his udget constrint. We normlize so tht the price of the risk-free sset is one. 11

13 Let n investor of type i hve initil endowment ssets w 0i. Thus, domestic investor chooses n, M to mximize E[{u w ~ 1 }*I ] 7 suject to the domestic udget constrint: w0 = M + n P 8 where the end-of-period welth of the domestic investor is: w~ = + r M + n u~ f It is well-known tht the expected utility of domestic investors cn e expressed s Ew 1 *I - 0.5RVrw 1 *I. We show in Appendix I tht mximizing the expected utility with respect to n leds to the following demnd function for domestic investors: n φ 1+ rf p φ, p = 10 R σ ε The demnd for A shres depends positively on the informtion φ nd negtively on the price, the degree of risk-version, nd the conditionl voltility of returns. Becuse trding in domestic clss shres is completely seprted from trding in the foreign clss shres, domestic shres re suject only to domestic mrket risk. In other words, the A shres re priced s if the B shres do not exist. Let P *.,. e some prticulr price function of x,φ such tht u nd P * re jointly normlly distriuted we will prove tht such price function exists. A foreign investor chooses n to mximize E[u w ~ * 1 * p; P ] 11 suject to the foreign udget constrint: 1

14 w0 = M + n p + nc pc 1 where the end-of-period welth of the foreign investor is: w~ = + r M + n u~ + n u~ f c c We see tht there is n dditionl component to the foreigners udget constrint in 1 nd 13, since they hve the option to invest in the risky sset in their own mrket s well s Chinese B shres. We show in Appendix I tht the demnd function n of foreign investors for the B shres is: * n p, p, n ; P = c E u ~ * P φ, x = p 1+ r p n RCov u ~, u ~ f c c RVr u ~ * P φ, x = p 14 The demnds of foreign investors depend oth on the ctul price of A nd B shres nd the A shre price function, since the ltter is informtive out the expected return nd vrince of the B shres. In ddition, the demnd for B shres depends on the demnd for C shres nd the covrince etween the returns of the B shre mrket nd the C-shre mrket. If the covrince is negtive, then investing in B shres provides diversifiction enefits for foreign investors, nd the B shre demnd is higher s result. Finlly, foreign investors demnd for the purely foreign sset n c is: n p, n = c c E u ~ 1+ r p n RCov u ~, u ~ c f c c RVr u ~ c 15 The equilirium price distriutions re functions P x,φ, P P x,φ, x, x c ; P * nd P c x, x c such tht, in ech mrket, the demnd for shres equls the supply ville for every reliztion of φ nd x i, i=,,c. Note tht P * is the A shre price function conjectured y the foreign investors, wheres P is the true A shre price function. In equilirium, the prticulr 13

15 price function P * conjectured y foreign investors is, in fct, the function P x,φ determined in the A shre mrket. Formlly, the equilirium price functions re determined y: n φ, P = x 16 * n P, P, x ; P = x 17 c nc Pc, x = xc 18 where we hve suppressed the rguments in the price functions for revity. 8 P x,φ is sttisticl equilirium---i.e., over time foreign investors oserve mny reliztions of u nd P * to lern the joint distriution of u nd P * nd, consequently, the joint distriution of u nd P *. Bsed on this knowledge, they will trde nd form expecttions such tht these joint distriutions persist over time. We shll now prove tht there exists n equilirium price distriution P * x,φ such tht u nd P * re jointly normlly distriuted nd, further, chrcterize this price distriution. Proposition 1. 1 Suppose neither domestic nor foreign investors oserve φ i.e., informtion is symmetric. Then: P 0 x = 1 E u RxVr u 1 r { ~ ~ } 19 + f P x, x = 0 c 1 E u RxVr u RxcCov u uc 1 r { ~ ~ ~, ~ } 0 + f 8 In specifying 18, we hve ssumed tht the demnd for C shres depends only on the supplies x nd x c, nd not on the A shre price function P. This is resonle ssumption, since the informtion φ is specific to the domestic sset, nd hs no vlue in pricing the C shres. 14

16 P x, x = c0 c 1 E uc RxcVr uc RxCov u uc 1 r { ~ ~ ~, ~ } 1 + f where P 0.,., P 0.,. nd P c0.,. re the A, B nd C shre price functions when domestic nd foreign investors do not know φ. Suppose domestic investors oserve φ, ut foreign investors do not. Then: P φ 1, x Rx r { φ σ = 1+ } ε P P, x, x ; P = f 1 E u P P x RxVr u P P x r { ~ = φ, ~ = φ, 1+ * * * c f Rx Cov u ~, u ~ } c c 3 P x, x = P 0 x, x 4 c c c c The expressions for Eu *P * nd Vru *P * re derived in the ppendix. The pricing equtions nd 3, without the covrince term, re similr to those in noisy rtionl expecttions model with symmetric informtion, such s equtions A7 nd A10 in Grossmn nd Stiglitz Further, the pricing eqution for the C shres is the sme whether there is informtionl symmetry in the Chinese mrket or not. This is ecuse there re no informtionl linkges etween the foreign stock mrket nd the Chinese stock mrket. Let the rndom vrile z, defined in A13 of the ppendix, e liner trnsformtion of P. Proposition chrcterizes the conditions under which the B shre prices re t discount or premium to the A shre prices. Proposition. 1 Suppose covu,u c =0. If : x x > R σ ε Vr ~ z Vr x Vr φ + Vr ~ z 5 15

17 then, Ep > Ep. Suppose domestic investors do not oserve φ nd covu,u c <0. If x vru x vru, then Ep 0 < Ep 0. Consider prt two of Proposition first. Let p 0 nd p 0 e prticulr reliztions of the price functions when there is symmetric informtion. Note tht 1, nd 3 imply tht Eu =Eu =Eφ. Then, from 19 nd 0, the difference in the A nd B shre prices is: p p = r f {[ R{ x u x u }] + RxcCov u uc } vr vr ~, ~ 6 Suppose covu,u c < 0: i.e., diversifiction enefits foreign investors. If x vru x vru i.e., the supply of A shres is higher thn the supply of B shres true for our smple ppendix II; nd domestic investors fce t lest s much idiosyncrtic risk on the domestic sset s foreign investors 9, then Ep 0 < Ep 0. Thus, consistent with erlier models of mrket segmenttion, the B shres trde t premium when there is no informtionl symmetry nd foreigners enefit from interntionl diversifiction. Now, consider prt one of Proposition. Let p nd p e prticulr reliztions of the price functions when there is symmetric informtion. From nd 3, we otin the following reltionship etween the mrket prices of A nd B shres: p p = 1 {[ φ E~ u*p x,φ = p ] + R[ x vr u ~ * P x,φ = p -x σ ε ] 1+ r f + RxcCov u ~, u ~ c } 7 From 7, whether B shres re trded ove or elow the price of A shres is determined y: the informtion symmetry effect the first two terms in squre rckets nd the 9 This follows since, from 5, vru vru implies tht σ ε Vrγ. 16

18 diversifiction effect the lst term. If Cov u ~, u ~ c = 0, the reltive prices of A nd B shres re determined purely y the informtion symmetry effect, which hs two prts: the difference etween the conditionl expecttions of future returns; nd the difference etween the conditionl vrinces of future returns. The difference rises due to the difference in the conditioning informtion sets of domestic nd foreign investors. Letting Cov u ~, u ~ c = 0, nd tking expecttions on oth sides of 7, we show in Appendix I tht the verge difference in conditionl expecttions is zero, while the verge difference in the conditionl vrinces is positive, if 5 is stisfied. Hence, Ep > Ep. 5 is likely to e stisfied if the right hnd side of the expression is smll, which hppens when the vrince of the A shre price is lrge. In this cse, the A shre price is reltively uninformtive, nd the informtion symmetry prolem is severe. Intuitively, reltive to foreign investors, domestic investors form more precise estimtes of the distriution of future returns, nd thus require lower expected returns now. B. The Reltive Pricing Model With Index Securities Without loss of generlity, ssume there re two B stocks: B 1 nd B. In ddition, investors cn trde in the B shre mrket n index security I, where the price of I, p I, is the weighted verge of the prices of stocks B 1 nd B. In other words, p I = w 1 p 1 + w p, where w = 1- w 1, w i >0 is the weight nd p i is the price of stock B i, i=1,. We continue to ssume tht the numer of stocks is one in the A nd C shre mrkets. In Surhmnym 1991 nd Gorton nd Penncchi 1993, the index security hs lower return vrince, nd hence the mrket mker s loss to informed trders is smller thn 17

19 when individul stocks re trded. As result, uninformed trders reduce their losses to informed trders y trding n index security, or sket of securities. It is interesting to see whether such scenrio holds in our model s well. Specificlly, do foreign investors trde more B shres, nd is the B shre discount lower s result of the B stock index? Let u I e the unknown future return nd n I the numer of shres ought or sold of the index security. Let u i e the future return of stock B i, i=1,. Note tht the mximiztion prolem for domestic investors does not chnge. Hence, the equilirium price function in the A shre mrket is still given y P in. The mrket clering conditions re n i = x i, i=1,,,c, I. Proceeding s efore, we cn clculte, for ech stock B i, i=1,, the equilirium price function P i nd the shres trded n i s follows: n i + w n i I = E u ~ i P * φ, x ~ ~ = p 1 + rf pi ncrcov ui, uc ~ * RVr u P φ, x = p i 8 P P, x, x i i c, x I ; P * 1 ~ * ~ * = { E ui P = P φ, x R xi + wi xi Vr ui P = P x, φ 1 + r f Rx Cov u ~, u ~ } c i c 9 Proposition 3. The introduction of n index security on B shres mkes no difference to: 1 the totl numer of B shres trded. the price of B shre stock. At first sight, Proposition 3 might pper to contrdict the results of Surhmnym 1991 nd Gorton nd Penncchi This is not so. The difference etween our model nd those of the other uthors is tht the A shre nd B shre mrkets re segmented. Since foreign nd domestic investors do not trde together in the B shre mrket, the existence of the 18

20 B stock index mkes no difference to the degree of informtionl symmetry fced y foreign investors. The effect is merely to crete nother security in which the foreign welth is invested in proportionl mnner. To clrify the ove point, suppose tht there re two A stocks nd n index on A shres. Suppose, further, tht domestic investors re llowed to trde individul A stocks, ut not the index, wheres foreign investors re llowed to trde the A shre index, ut not the underlying stocks. In ddition, foreign investors my trde individul B shre stocks. To simplify the model, ssume there is only one B stock nd no C stock. Our results do not depend on these ssumptions. Denote the two A stocks: A 1 nd A, nd the A shre index security I, where the price of I, p I, is the weighted verge of the prices of stocks A 1 nd A. As efore, p I = w 1 p 1 + w p, where w = 1- w 1, w i is the weight nd p i is the price of stock A i, i=1,. Let u I e the unknown future return nd n I the numer of shres ought or sold of the index security. Let u i e the future return of stock A i, i=1,. We clculte the price function P nd the demnd n of the B shres, s follows: ~ * ~ ~ * E u 1, * P = p + r f p ni RCov u u I P = p n p, p, ni ; P = ~ 30 * RVr u P = p P P, x, x I ; P * 1 ~ * = { E u, ~ P = P φ x RxVr u 1 + rf ~, ~ * Rx Cov u u P = P φ, x } I I P * = P φ, x 31 Compring 14 nd 3 with 30 nd 31, we see tht, if covu,u I *P < 0, then investment in B shres is higher nd, further, the price of B shres is lso higher. In other words, 19

21 if the A shre index llows foreign investors to hedge the risk of trding B shres, they would e willing to invest more nd py higher price for the B shres. Proposition 4. Suppose foreign investors could trde n index security on A shres, ut not the underlying stocks. If the return on the index security is negtively correlted with the B shre return, then, reltive to the sitution when no index security is ville: 1 the totl numer of B shres trded is higher. the price of B shre stock is higher. IV. EMPIRICAL RELATIONSHIP BETWEEN CHINESE A AND B SHARE PRICES A. Smple nd Correltions Between Chinese nd Foreign Mrkets Our smple consists of 39 firms issuing oth A nd B shres identified from the DATASTEAM dtse. 10 Of these, 3 firms were listed on the SSE nd the remining 16 on the SZE. Our test period egins in Jnury 1994, the month in which Chin unified the exchnge rte system, in order to minimize ny effects rising from the dul exchnge rtes in effect efore tht time. The listing dtes of the A nd B shres nd the ownership structure of the smple firms re in Appendix II. For ech pir of clss A nd B shres, we collect dily prices nd trding volume from the DATASTRRAM dtse. Since A nd B shres re trded in different currencies, we convert the Shnghi A shre price into US$ nd the Shenzhen A shre price into HK$, using the Renmini/US$ nd Renmini/HK$ spot rtes respectively. 11 Similr to Biley 1994, we 10 Dt for 19 other firms issuing oth A nd B shres were not ville, ecuse either their trding history ws too short, or ecuse there were too few B shre trdes. 11 The spot exchnge rte s quoted t the close of dy ws used to convert dily A shre prices into the equivlent foreign currency prices i.e., US$ price for Shnghi A shre nd HK$ price for Shenzhen A shre. 0

22 express the discount of the B shres s frction of the A shre prices, i.e., the B shre price minus the A shre price, divided y the A shre price. We lso collect dt on mrket indices for the Shnghi A nd B shres nd for the Shenzhen A nd B shres. To nlyze the reltionship etween the B shres nd foreign mrkets, we select representtive indices from mrkets tht re closely relted to the Chinese mrket: Hng Seng index HSI for the Hong Kong stock mrket, Hng Seng Chinese Enterprises Index HSCEI for the overses Chinese stocks, Nikkei 5 Index NIKKEI for the Jpnese mrket, nd S&P 500 Index S&P for the US mrket. Tle reports the distriution of the dily verge discount for B shres from Jnury 1994 to Decemer Almost ll B shres experienced sustntil price discounts in this period. The men nd medin of the dily discount for the whole smple re percent nd percent, respectively. The dily verge discount for the Shnghi B shres is percent, higher thn percent for the Shenzhen B shres. A time-series of verge dily price discounts for ll B shres nd seprtely for Shnghi nd Shenzhen B shres re plotted in Figure 1. Tle 3 reports the ivrite return correltions mong the A nd B shre indices, s well s the Hong Kong, Jpnese nd US mrket indices. The overll results suggest tht the Chinese mrket is still isolted, even fter the introduction of B shres, nd tht the prices of B shres re sensitive only to A shre prices nd hve little reltionship to the foreign mrkets. The sme For our smple period, the men nd stndrd devition of the exchnge rte were i.e., 100 Yuns = US$11.81 nd for US$/Renmini, nd i.e., 100 Yun = HK$91.51 nd for HK$/Renmini. Thus, the exchnge rtes were reltively stle during our smple period, which is not surprising since the HK$ is pegged to the US$ nd the Yun ws stilized t the officil exchnge rte. 1

23 findings re reported in Biley The correltion results indicte tht the B shre discounts re unlikely to e ffected y price chnge in the foreign stock mrkets. Specificlly, we find tht the Shnghi A shre mrket is highly correlted with the Shenzhen A shre mrket the correltion coefficient ρ=0.7754, nd the Shnghi B shre mrket is positively relted to the Shenzhen B shre mrket ρ= Also, while the B shre mrkets show significnt correltion with the A shre mrkets, they show little correltion with the Jpnese nd US mrkets. For exmple, while the correltion coefficients of SHAIB/SHAIA nd SHAIB/HSCEI re positive nd significnt, the correltion coefficients for SHAIB/NIKKEI nd SHAIB/S&P re not different from zero. The Hong Kong mrket ppers more correlted with the Shnghi B shre mrket thn with the Shenzhen B shre mrket. These results indicte tht the reltive pricing of Chinese A nd B shres is not primrily relted to the diversifiction enefits of foreign investors. B. Led-Lg Reltionship Between A nd B Shre Returns To shed light on the informtion symmetry etween A nd B shres, we test whether A shre returns led B shre returns. If oth A shres nd B shres rect to the new informtion in the sme mnner, we would expect price movements in these two mrkets to e contemporneously correlted. On the other hnd, if one mrket rects to informtion fster thn the other mrket, we my oserve led-lg reltion. We use the following functionl form to study the led-lg reltionship etween A shres nd B shres,

24 3 R = d + d R ε 3 B, t 0 k = 3 k A, t+ k + B, t where R B,t re dily B shre returns for dy t nd R A,t+k re the corresponding dily A shre returns for dy t+k. The coefficients with negtive suscripts d -3, d -, d -1 re led coefficients- --i.e., if these coefficients re significnt, then current B shre returns re relted to pst A shre returns; hence, A shre returns led B shre returns. Similrly, the positive suscripts d 3, d, d 1 re lg coefficients tht indicte whether A shre returns lg B shre returns. Exmintion of the dt indictes tht three leds nd three lgs re pproprite. Tle 4 presents the estimtion coefficients of the leds nd lgs for the entire smple. Tle 5 reports the estimtion results for two susmples the Shnghi nd Shenzhen stock exchnges. Both tles report qurtiles, minimum nd mximum vlues of the estimted coefficients, together with the numer of significnt coefficients otined. For exmple, q 1 indictes the mximum led or lg vlue in the first qurtile for ech coefficient. The t-sttistics re indicted in prentheses. For the whole smple in tle 4, the proportion of significnt led coefficients is out 36% for one-dy led, nd out 5% for one-dy lg. F led nd F lg re F-sttistics tht test whether the led coefficients d -3, d -, d -1 nd the lg coefficients d 1, d, d 3 re, respectively, jointly zero. According to the F-sttistics, for 19 out of 39 stocks, the null hypothesis tht ll the led coefficients re jointly zero is rejected. In the cse of lg coefficients, the F-sttistics reject the null hypothesis for only 6 stocks. Consistent with Wo 1997, we find some evidence of two-wy informtion flows etween the A shre nd B shre mrkets. However, we lso find tht, consistent with our 3

25 informtion symmetry hypothesis, A shre returns re more likely to led B shre returns, on verge, rther thn the other wy round. From tle 5, for the Shnghi stock exchnge, 6 or 6 percent of 3 stocks hve significnt one-dy led coefficients, with no stock hving significnt two-dy led coefficients. In contrst, no stock hs significnt one-dy lg coefficient, ut 4 stocks hve significnt two-dy lg coefficients. The null hypothesis is rejected for 8 stocks for the led coefficients, nd only 3 stocks for the lg coefficients. A similr pttern is oserved for the Shenzhen stock exchnge. 50 percent of the stocks hve significnt led coefficients for one-dy led, while only 1 percent of lg coefficients re significnt for one-dy lg. The F-sttistics indicte tht, for 11 out of 16 stocks, the null hypothesis tht ll the led coefficients re jointly zero is rejected. In the cse of lg coefficients, the F-sttistics reject the null hypothesis for only 3 out of the 16 stocks in Shenzhen. C. Foreign Medi Coverge Impct One wy to nlyze informtion symmetries etween domestic nd foreign investors is to look t the impct of English medi coverge. 1 For B shre investors, the English medi report is n importnt source of informtion, since firms with wide coverge in the medi my e esier to monitor, reducing informtionl symmetries etween domestic nd foreign investors. Hence, we conjecture tht firms with greter medi coverge will hve lower price discounts for their B shres compred to firms with lower pulicity. To mesure the degree of the English medi coverge, we count the numer of times firm is mentioned in the hedline of n rticle reported in the English newsppers. Specificlly, 1 We thnk Stephen Brown for this suggestion. 4

26 we serch the Wll Street Journl Index through the Dow Jones Informtion Retrievl Service for the yers 1995 to 1996, nd count ll cittions for ech firm. Then we rnk firms sed upon the mount of news coverge nd the mgnitude of B shre discount, nd compute the rnk correltion etween the two series. Tle 6 presents the results of the rnk correltion tests. The rnk correltions for Shnghi B shre nd Shenzhen B shre re nd , respectively. The p-vlues from the Person tests re significnt t the 10 per cent threshold level for oth Shnghi nd Shenzhen B shres seprtely. 13 Thus, consistent with the informtion symmetry hypothesis, the results show negtive reltionship etween numer of the English news report nd level of the price discounts. D. Cross-Sectionl Tests of the Determinnts of B Shre Discounts Our theoreticl model implies reltionship etween the A shre nd B shre prices, s given y 7. We first express 7 in form menle to empiricl testing. Define p = 1+r f p - p. We show in the ppendix tht p cn e expressed s: R σ εvr x p = φ Vr φ ~ x + Rx Vr u σ x Cov u, u ~ E φ R R Vr z Vr φ ε ~, ~ + RxcCov u uc σ ε Vr x xvr φ 33 To test the model, we form empiricl proxies for the right-hnd side vriles in 33 to cpture the cross-sectionl vrition in the B shre discounts. Recll tht z is simply liner trnsformtion of the A shre price. We show in the ppendix tht p, the price discount on B 13 The rnk correltion ws not significnt for the whole smple, nd therefore ws not reported. 5

27 shres, is: 1 positively relted to domestic investors privte informtion φ; negtively relted to [Cov u ~, u ~ /Vr ~ p ]; nd 3 positively relted to the vrince of B shre returns Vru. These three fctors cpture the effect of informtion symmetry on the B shre price discount. In ddition, the prmeters R, x, x cpture dditionl effects due to investor risk version nd the supplies of the A nd B shres. 33 predicts tht the price discount on B shres is negtively relted to the reltive supply of A shres x /x. Intuitively, high vlue of Cov u ~, u ~ indictes tht A shre returns re informtive out B shre returns. A high vlue of Vr ~ p mens tht the price of A shres is very noisy, which leds foreign investors to lern φ imprecisely. Thus, the degree of symmetric informtion nd the B shre discount re negtively relted to [Cov u ~, u ~ /Vr ~ p ], since high vlue of the vrile indictes tht the B shreholders otin lot of informtion out φ from oserving the A shre price. Similrly, high vlue of Vru is indictive tht A shre price is noisy indictor of φ. Hence, the B shre discount is positively relted to Vru. For empiricl investigtion, it is convenient to rewrite 33 in the following form. For stock i, i=1,...39, we write: DIS i = SBA i + VARB i + 3 SBF i + 4 INFO i + 5 RAB i + ε i 34 where DIS = the verge dily discount of the B shre prices, where the dily discount for stock i on dy t is D it =P it -P it /P it, with P it nd P it eing the A nd B shre prices, respectively. SBA = Cov u~, u~ / Vr ~ p, mesuring the return sensitivity of the B shres to the A shres. For ech stock with A nd B shres, we clculte the smple covrince etween their 6

28 returns, nd divide y the smple vrince of the A shre prices. Since higher vlue of SBA indictes lower degree of informtionl symmetry, we predict 1 to e negtive. VARB = Vru, the smple vrince of the B shre returns. From 33, is expected to e positive. SBF = Cov u~, u~ / Vr u ~, mesuring the foreign mrket sensitivity of B shre. The c c foreign mrket portfolio is proxied y the S&P 500 Index. 14 SBF is derived y running, for ech stock, time-series regression of the B shre returns on the S&P 500 Index returns. We expect 3 to e negtive. INFO = the numer of compny cittions in the Wll Street Journl index, s descried erlier in section B. Since this vrile is proxy for the informtion vrile φ, we expect 4 to e negtive. RAB = the rtio of the numer of A shres outstnding over the numer of B shres outstnding. From 33, 5 should e negtive. We lso include firm size SIZE nd n exchnge dummy vrile D in the regression. SIZE is the mrket cpitliztion of the firm i.e., the numer of A shres times the A shre price, plus the numer of B shres times the B shre price. SIZE is widely used to explin stock returns in the finnce literture, nd my ct s nother proxy for informtion symmetry for exmple, more nlysts my follow lrger firms. D tkes on the vlue 1 when the stock is trded on the Shnghi Stock Exchnge, nd zero on the Shenzhen Stock Exchnge. From our erlier results, the B shre discounts re higher for Shnghi, nd so we expect the dummy coefficient to e positive. 14 We lso use the Hng Seng index nd Nikkei 5 index s lterntive proxies of the foreign mrket portfolios. The results re similr to the S&P 500 index, so we do not report the results in the pper. 7

29 We estimte eqution 34 using OLS. Tle 7 summrizes the regression results. The reported t vlues re corrected for heteroskedsticity, following the method of White Models 1-3 run the regression with different vrious susets of our right-hnd side vriles. Model 1 uses the three model-sed vriles SBA, VARB, nd SBF, plus the exchnge dummy, s explntory vriles. These vriles together explin 40 percent of the vrition in the B shre discounts. Adding the medi coverge vrile INFO model increses the djusted R- squre to 0.5. With SIZE included model 3, the djusted R-squre is The sign nd significnce of the coefficients re consistent in ll models where they re used. The coefficients on SBA nd SBF hve the right signs negtive, ut re not significnt except for the coefficient on SBF in model 3. In contrst, the coefficient on VARB hs the right sign positive, nd it is significnt. The INFO vrile nd the exchnge dummy re lso significnt, with the expected signs. SIZE is negtive nd significnt, consistent with the findings of Biley Model 4 uses the entire set of explntory vriles, nd explins 67 percent of the cross-sectionl vrince of the B shre discounts. All estimted coefficients hve the right sign nd re significnt t the 1 percent level, except for the coefficients on SBA nd SBF, which re not significnt. The two proxies for informtionl symmetry, VARB nd INFO, re significnt nd of the predicted signs. The negtive nd significnt sign on SIZE lso provide dditionl support for the informtion symmetry hypothesis. Supply fctors, proxied here y the reltive supply of A shres, is lso importnt. The coefficient on this vrile is negtive nd significnt, consistent with the results of Chen nd Su Overll, these results provide strong support for the informtion symmetry hypothesis, s well s the predictions of our theoreticl model. 8

30 Although informtion symmetry nd mrket microstructure fctors explin 67 percent of the cross-sectionl vrince in the B shre discounts, the highly significnt intercept term indictes tht other vriles my hve dded explntory power. This is not surprising, given the lrge mgnitude of the oserved discounts in the B shre prices. Fctors such s politicl nd economic risks, foreign nd domestic investor sentiments my lso ply roles in determining the B shre discounts. This is n venue for future reserch. V. CONCLUSION Contrry to evidence tht foreigner investors py higher prices thn domestic investors for locl shres in other countries, we find tht, in the Chinese stock mrkets, foreign clss B shres trde t n verge discount of out 60 percent to the prices t which domestic A shres trde. The usul diversifiction rgument cnnot explin this phenomenon. We rgue tht one reson for the discount is tht foreign investors hve less informtion out locl firms, reltive to domestic investors. We develop simple model, incorporting oth symmetric informtion nd mrket segmenttion, to explin the reltive pricing of A shres nd B shres. Our model predicts tht, whether cross-listing leds to premi or discounts in trding of the foreign clss shres, depends on the reltive mgnitudes of the informtion symmetry effect nd the diversifiction effect. The former effect leds to discounts for B shres, while the ltter effect implies premi for B shres. Our model identifies proxies for informtionl symmetry, tht we lter use for our empiricl tests. Finlly, we show theoreticlly tht introduction of n index security on the domestic A shres, tht cn e trded y foreign investors, improves the liquidity of the B shre mrket. 9

31 We show empiriclly tht the informtion symmetry hypothesis provides significnt, though prtil, explntion s to why the B shres consistently trde t lower prices thn the A shres. First, we find tht A shre returns re more likely to led B shre returns, rther thn the reverse. Second, the B shre price discount on stock is negtively relted to its coverge in the English medi. Finlly, using cross-sectionl regression, we show tht the B shre discount is significntly relted to proxy for informtionl symmetry tht is sed on our model, nd to the medi coverge vrile. Together with n exchnge dummy, nd stock s size i.e., its mrket cpitliztion, the informtion symmetry proxies explin 67 per cent of the crosssectionl vrince of B shre price discounts. Although we nlyze the discount/premium in the Chinese stock mrkets, the results generlize to other cross-listed securities where informtionl symmetry is mjor fctor. Of course, our focus on the informtion effect does not rule out other fctors tht could explin B shre discounts. For exmple, the B shre discounts could e cused y irrtionlly high domestic demnd for the A shres, or foreign investors sentiment towrds the Chinese stocks. The interest rte differentil etween the domestic nd foreign mrkets is nother fctor tht my influence the level of the discounts. Our model hs strcted from these fctors, ut they remin importnt res for further study. 30

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