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

37 floa/gdp raio of he China s sock marke leads o a remendously liquid and speculaive marke, because of he excess of demand over supply of he available socks in he marke (see able 2.3). Guo e al (2006) find evidence ha for dually lised H (Hong Kong) and A (Shanghai) shares, he cos of capial is lower and liquidiy measured by urnover raio is far greaer for A shares han hose of heir H shares counerpars. Table 2.2 Raio of Marke Capializaion o GDP in China GDP (RMB 10 8 ) Marke capializaion (RMB 10 8 ) % (Marke Capializaion o GDP) Tradable Marke Capializaion (RMB 10 8 ) % (Tradable Marke Capializaion o GDP) % % % % % % % % % % % % % % % % % % % % % % % % % % % % 1. Source: NBSC, CSRC 2. Marke Capializaion includes A and B shares only Table 2.3 Turnover raio of radable A shares in SHSE and SZSE SHSE % SZSE %

38 Source: Shanghai Sock Exchange, Shenzhen Sock Exchange iv. Problem of ownership srucure Apar from he small size domesic sock marke, mos of he domesic lised SOEs have small marke capializaion wih highly concenraed shareholders. A he end of 2002, 64% of he domesic lised SOEs had fewer han 50,000 shareholders and fewer han 5% had more han 150,000 shareholders (Waler and Howie, 2003:132). In erms of concenraion of share holding, China is a a level similar o hose in mos Wes European counries (Faccio and Lang, 2002). Wha differeniaes China s ownership srucure from he res is he ideniy of he conrolling shareholders; as he majoriy of he shares are owned, direcly or indirecly, by he sae. Furher, China's sock marke was developed under a weak legal framework ha offered minoriy shareholders lile proecion. La Pora e al. (1998) developed LLSV indicaor 1 o measure shareholder righs proecion, China scored 3, which was lower han he average score of 3.61 for all oher ransiional economies (Pisor and Xu 2005). However, some papers repored ha he acual proecion for shareholders in China is 1 LLSV is he iniial capial leer of four auhors: La Pora, R., Lopez-de-Silanes, F., Shleifer, A., Vishny, R. 38

39 probably lower han wha he index suggess (Tenev and Zhang 2002; Allen, Qian, and Qian 2005; Pisor and Xu 2005 In erms of he relaionship beween ownership srucure and he performance of he Chinese lised firms, here are several papers in he lieraure. Qi, e al. (2000) sudied all firms lised in he Shanghai Sock Exchange (SHSE) from 1991 o 1996, and found ha he ownership srucure composiion and relaive dominance by various classes of shareholders can affec he performance of he lised firms. Their empirical sudy suggesed ha firm performance increases wih he degree of relaive dominance of LP shares over sae shares. Similarly, Hovey e al. (2003) indicaed ha hough he ownership concenraion has lile explanaory power, he srucure does maer. Legal person's shareholdings are posiively relaed o firm valuaion. Wei e al. (2005) invesigaed he relaionship beween ownership srucure and firm value across a sample of 5,284 of China's parially privaized former sae-owned enerprises (SOEs) from They found ha a significan convex relaion exiss beween sae and LP shares and Tobin s Q which measures firm s value. They also found ha foreign ownership is significanly posiively relaed o Tobin's Q. Ding e al (2007) analyzed 273 privae-owned and sae-owned Chinese companies lised in 2002; hey revealed ha an invered U-shaped relaionship exiss beween ownership concenraion and earnings managemen pracices. I is clear ha privae-owned lised companies end o exaggerae heir accouning earnings. However, he enrenchmen effec of ownership concenraion on earnings managemen is weaker in privae-owned lised firms han in sae-owned lised firms. 39

40 2.2.4 Hardening of he Budge Consrains and Non-radable Shares Reform Hard budge consrains are becoming an increasingly common feaure for he Chinese lised firms. On he one hand; he sae-owned commercial banks are decreasingly favouring SOEs and are puing greaer emphasis on evaluaing loan applicaions on heir profi-making poenial since bank officers are now personally responsible for heir lending decisions. On he oher hand, under pressure from he CSRC, he lised firms are less likely o make asse-sripping hrough dividends paymens in cash. The benefi of liquidaing sae-owned shares on he secondary marke is no only o clear he angles in corporae governance, bu he proceeds from he selling of sae-owned shares can be used o offse he huge nonperforming loans and keep he capial adequacy raio sufficienly high by he banking secor. (Nefci and Menager-Xu, 2007: 232). Under such siuaions, as well as he five-year slump of China s sock marke, in April 2005, he China Securiies Regulaory Commission (CSRC) launched a new approach for sae share reform o make all non-radable sae shares become radable on he marke. This is an imporan landmark in China s sock marke, o virually privaize and change he conrol righs of he Chinese lised SOEs. The sae share reform, as announced by he CSRC as a op prioriy in China, is he bigges reform in China s sock marke hisory, and is criical for he privaizing process. Meanwhile, he iming for carrying ou his reform seems o be perfec, afer he marke slumped during he pas 4 or 5 years; he Shanghai Composie Index fell from over 3000 o less 1000, he marke capializaion dropped by wo-hirds. The sae share reform is a marke-based negoiaion beween he privae 40

41 shareholders holding radable shares and he sae shareholders holding non-radable shares. I is a marke-based negoiaion because he share merger gives consideraion o he privae shareholders and uses consideraion o ransfer rading righs. The consideraion includes more bonus shares, warrans, and cash as compensaion o holders of radable shares. For example, in order for non-radable shares o be radable, each public shareholder will receive a cerain number of shares, or a number of warrans, or cerain cash as consideraion. The public shareholders will decide a he shareholder meeings wheher hey considered i a fair consideraion, wheher hey should accep i. Furher, foreign ownership ineviably became involved in his sae share reform. In he las few years, he general legal and regulaory reforms have been upgraded o faciliae increased foreign ownership in lised companies. In he A share marke, he radable share marke side, he QFII sysem was inroduced in 2002 o open up foreign ownership in he public radable share marke. Then on he non-radable share side, a series of mergers and acquisiions (M & A) rules were pu ino effec from 2002 o This new M & A framework has opened up foreign ownership in lised companies hrough acquiring non-radable shares via privae negoiaions. For example, on Ocober 25, 2005, Carlyle Group, an American privae equiy fund, announced a leveraged buyou of 85% of he claims Xu Gong Mechanism, he deal was worh by US$ 375 million. (Nefci and Menager-Xu, 2007:234) So far, he lieraure abou he Chinese sae share reform is no very large, since his reform process is sill ongoing and is ye o be compleed. However, several papers such as Green (2003b) who gave an inroducion abou he background of he sae share reform, and how i works and Belrai and Boroloi (2006) who repored ha his 41

42 reform process has generaed a saisically significan 8 percen posiive abnormal reurn over he even window. Table 2.4 Chronology of sae-owned shares reform November 1999 December 1999 Jun 13, 2001 Ocober 23, 2001 April 29, 2005 May 9, 2005 May 10, 2005 May 25,2005 June 1, 2005 June 20, 2005 Augus 24, 2005 Regulaors approve he sale of a porion of sae-owned shares by 10 firms Landmark sales of sae shares in Guizhou Tyre and China Jialing Indusry Moorcycle perform badly. As share prices are oo high invesors fail o ake up much of he sock on offer. Beijing suspends planned sales for he eigh oher firms. The Sae Council (he cabine) requires all sae-owned firms planning IPOs as well as lised firms issuing more shares o raise he equivalen of 10% of he offering by selling sae shares. The money mus be given o he Naional Social Securiy Fund o help finance he Public welfare sysem. This is he firs full-scale aemp o solve he problem of sae-owned shares. The aim is o allow all shares evenually o be raded on he marke. Regulaors suspend he reform as a resul of 30% slide in he benchmark index in jus hree monhs. Expecaions ha Beijing will evenually sell sae shares haun he marke hereafer, pushing down share values whenever rumours abou he program emerge. Beijing issues rules o revive he sae-owned share reform. The approach is made more aracive o invesors by requiring companies o win approval of wo-hirds of public shareholders before floaing sae-owned shares. Also, a phased, hree-year limi on he number of shares ha can be sold o he marke is esablished. Sany Heavy Indusries Co. and Tsinghua Tongfang Co. sar he reform on a rial basis. Four companies announce plans o give compensaion, in cash and bonus shares, o public shareholders; he aim is o encourage a favourable voe by shareholders. China quiely suspends IPOs, o ease invesor worries abou he supply of new shares coming o he marke. China s shares end a heir lowes level since early 1997 on renewed worries concerning sae-owned share sales. Regulaors pick he seel mill Baoshan iron and Seel and Three George Dam operaor Yangz Elecric Power o be among 43 firms subjec o he reform. Regulaors open he reform o all 1,400 lised firms. 42

43 Sepember 12, 2005 Source: Nefci and Menager-Xu, 2007 Fory firms, including Minsheng Banking Corp., announce hey will volunarily adop he sae-share reforms. The group of companies joining he reform scheme begins expanding quickly. 2.3 The segmened marke wih price puzzle The shareholder srucure of a Chinese lised firm is around wo-hirds non-radable shares plus one-hird radable shares, and he radable shares could be owned by domesic invesors as A share holders or foreign invesors as B or H share holders. Alhough hese differen shareholders have he same voing righs and cash flow righs, hey have o pay differen prices for each ype of shares. For example, he domesic invesors have o pay much higher price for A shares while an invesor from Hong Kong or he US pay considerably low prices for shares which provide hem wih he idenical righs and benefis o hose of an A share holder. The price differenials persis all along since he beginning of he China s sock marke, and here is no way for he domesic Chinese ciizens o arbirage beween A share marke and B/H share marke due o he resricions on exchange currency; likewise here is no way for foreign invesors o earn arbirage profi jus simply because hey do no hold Chinese ciizenship A shares On he domesic sock exchanges, a firm may issue radable A shares and B shares. The A shares can only be raded by mainland Chinese invesors, from December 2002; cerain qualified foreign insiuional invesor (QFII) may also rade in he A-share marke. 43

44 2.3.2 B shares Like many oher sock markes in emerging counries, China s sock marke has placed explici resricions on foreign ownership from is beginning. In 1992, he CSRC allowed companies o issue he so-called Special Shares (laer, designaed as B shares) which were he only shares in China s sock marke foreign invesors have access o. In Shenzhen sock exchange, he B shares are denominaed in Hong Kong dollars, and in Shanghai sock exchange; hey are ransaced in US dollars. The shareholders of boh A and B shares are recognized o have equal saus by he Securiies Law of China. By December 2006, here were a oal of 109 firms wih B share lising. 86 of hese companies also lised heir shares as A shares while 23 of hem did no. B share marke consiues a very small proporion of he whole marke; i accouned for less han 5% of he overall marke capializaion and rading volume during he pas decade (CSRC websie). A shares and B shares have differen accouning sandards and informaion disclosure requiremens. Inernaional Accouning Sandards (IAS) are used o prepare accouning repors for he B share firms, while China s accouning regulaions, PRC Generally Acceped Accouning Principles (PRC GAAP) are used o prepare accouning repors for he A share firms. The IAS is more conservaive han he PRC GAAP, so he level of disclosure for he B shares is higher han ha for he A shares. Therefore, he profi values, asse values, and book values ec. are differen beween he IAS and PRC GAAP saemens. The B share companies need o prepare wo ses of financial 44

45 saemens: one is based on IAS for he B share holders, and he oher is based on PRC GAAP for he A share holders 2. The PRC GAAP and IAS numbers are released o he shareholders on he same day, and he differences beween he wo ses of numbers are disclosed in he PRC GAAP saemens as well as he IAS saemens, so here are no informaion barriers or advanages o eiher he A share holders or he B share holders. Alhough segmened markes are no unique o he Chinese sock marke, he Chinese marke is disincive because of is complee segmenaion. The segmenaion in mos oher markes is only parial, foreign invesors are allowed o own he foreign caegory of shares only, while domesic invesors can own boh local and foreign shares. A price discoun puzzle arises in China since in his marke, hough A and B shares have idenical voing righs and cash flow righs, A shares coninue o be raded a a higher price premiums relaive o he corresponding B shares. However, his conradics mos oher findings on he impac of foreign ownership resricions on asse reurns. For example, Hieala (1989) for Finland sock marke; Lam and Pak (1993) for Singapore; Bailey and Jagiani (1994) for Thailan; Sulz and Wasserfallen (1995) for Swizerland; Domowiz e al. (1997) for Mexico; and Bailey e al (1999) for sock markes in 11 counries -- all hese sudies gave supporive evidence ha shares available o foreigners are usually priced a a premium relaive o ha of he domesic shares, which are oherwise idenical bu only for he domesic invesors. China is he only excepion, where foreign B shares are priced a huge discouns compared o he price of he domesic A shares. A number of papers have sudied he B shares price discoun puzzle, and ried o explain i from several aspecs associaed wih China s capial markes. The mos 2 Major differences beween PRC GAAP and IAS are summarized by Bao and Chow (1999) 45

46 imporan papers include Bailey (1994), Ma (1996), Chakravary, Sarkar and Wu (1998), Chui and Kwok (1998), Poon, Firh and Fung (1998), Fernald and Rogers (2002), Sun and Tong (2000), Chen, Lee and Rui (2001), Eun, Janakiramanan and Lee (2001). Bailey (1994) was he firs o uncover he discoun puzzle; he aribued i o he lower opporuniy cos of capial for he A shares, because here was nearly no alernaive invesmen vehicle available for he domesic ciizens oher han low-yielding bank accouns. As a resul huge amoun of Chinese domesic savings were driven ino sock invesmens. The limiaion of he above research is he small sample size ha only covered he preliminary daa of 8 lised companies for one year ime period. In addiion o he low cos of capial as suggesed by Bailey (1994), Ma (1996) also proposed some oher explanaions, such as differen aiudes owards risk beween A share and B share invesors, differences in liquidiy beween A share and B share markes, porfolio diversificaion inenion of foreign invesors, and differen reacions of domesic and foreign invesors o regulaion changes. Chen, Lee and Rui (2001) found evidence ha high B share price discoun is primarily due o he illiquid B share marke, so B share have a higher expeced reurn and lower price o compensae invesors. Adoping a similar approach as Bailey (1994), Fernald and Rogers (2002) also showed evidence ha domesic invesors have lower expeced reurn han foreign invesors, and which is due o lower risk ha Chinese ciizens were exposed o. Apar from he explanaion relaed o liquidiy and cos of capial, Poon, Firh and Fung (1998) proposed ha he heory of invesor recogniion may consiue an imporan explanaion for pricing behaviour in a segmened marke. The heory of Invesor recogniion was suggesed by Meron (1987) according o which an increase 46

47 in he size of he firm s invesor base will lower invesors expeced reurns and increase he marke value of he firm s shares. Poon e al. (1998) sudied he impac of issuing B shares on he price of exising A shares, and found a significan negaive abnormal reurns on he A share firms which also issued B shares; which implies ha he demand curve for equiy shares is downward sloping. Anoher line of sudy on he B share discoun is subsiue effec proposed by Sun and Tong (2000), which used he model by Sulz and Wasserfallen (1995). Basically, hey suggesed Chinese H shares and Red Chips lised in Hong Kong, as well as he Chinese ADRs lised in he US offer good subsiues for he B-shares lised in Shanghai and Shenzhen, so foreign invesors have more elasic demand for China B-shares. The availabiliy of hese socks in he US and Hong Kong means ha foreign invesors can ge hem from he US or Hong Kong markes insead of from he B share markes in Shanghai and Shenzhen. Yang and Lau (2005) exended he subsiue effec of Sun and Tong (2000); hey found ha he number of shares and rading volume of he Chinese firms raded in he US are also significanly negaively relaed o he B share premium. The subsiue effec from hese socks is sronger han ha from he Chinese socks lised in Hong Kong. Finally, some papers sugges he informaion asymmery paern relaed o he Chinese segmened sock marke can clarify his discoun puzzle. Chakravary, Sarkar and Wu (1998) developed a model by involving a proxy measuring asymmeric informaion beween A and B share invesors, hey argued ha i is because foreign invesors have less informaion abou he local firms, relaive o domesic invesors ha leads o he B share discoun. On he oher hand, Chui and Kwok (1998) argued because of he informaion 47

48 barriers in China, foreign invesors are beer informed, due o sric disclosure requiremens in he overseas sock exchanges, han he Chinese domesic invesors wih respec o he value of he Chinese socks, and hey found robus resuls of he asymmeric cross-auocorrelaion beween A share and B share in erms of lagged reurns and rading volumes. Bergsrom and Tang (2001) adoped asymmeric informaion measuremens of Chakravary, Sarkar and Wu (1998), as well as considered oher facors, such as liquidiy effec measured by bid-ask spread and relaive rading volume; diversificaion effec measured by he correlaion of B share reurn and porfolio reurn; clien bias effec; company size; risk-free reurn differenials beween foreign and domesic invesors; and foreign exchange risks, and repored all hese facors are significanly relaed o B share discoun. A he end of 2000, here were million A share accouns and million B share accouns on he SHSE. On he SZSE, he figures were million and million for he A and B share accouns respecively. The dramaically small and inacive B share marke has roubled he Chinese auhoriies for a long ime. As early as in April and June of 2000, Tu Guangshao, he presiden of he Shanghai Sock Exchange, and Dai Xianglong, he governor of he People s Bank of China, acknowledged ha difficulies exised in he B share marke bu expeced hem o be resolved wih greaer inernaionalizaion of he markes hrough, for example, he liberalizaion of he capial accoun. Almos one year laer, on February 19, 2001, he CSRC announced ha domesic invesors would be allowed o open rading accouns for B shares. In one research carried ou afer he inroducion of he new marke regulaion in China, Karolyi and Li (2003) observed wide-ranging differences in he discoun changes 48

49 across heir sample of socks. B-share discouns ranged from 56 percen o 90 percen before February 19, 2001, however, afer ha dae, he discouns ranged from premiums of 381 percen o discouns of 56 percen. And only for small marke capializaion and wih subsanial pas-reurn momenum, he B share discoun has declined from he period when his regulaory change was announced. However, his decline is found o be unrelaed o he firm s risk and liquidiy aribues H shares For is special geographical and poliical reason, Hong Kong is he favourie overseas marke place of he Chinese governmen o lis firms, especially SOEs. Tsingao Beer became he firs Chinese SOE o lis direcly on he SEHK in July 1993, and raised capial of approximaely US$115 million. As of February 2006, a oal of 125 Chinese companies had lised H shares on he Hong Kong and overseas sock exchanges, raising US$ billion,,31 of hese H share companies had also issued and lised A shares domesically (Nefci and Menager-Xu, 2007:6). The Chinese H share firms ac more like he Hong Kong lised firms raher han he Chinese lised firms which only issue A shares and he performances of he H share firms are beer han hose of firms issuing only A shares. The main reasons may come from several aspecs of he markes, such as he legal sysem of Hong Kong which helps o bring beer corporae governance pracice, high accouning sandards in SEHK which offer sufficien informaion release, and arificially packaging of he SOEs before heir lising in Hong Kong (Huang and Song, 2005). 49

50 In conras o mainland China s civil law sysem, Hong Kong mainains he common law radiion esablished by he Briish colonial rule. Alhough Hong Kong has been a special adminisraive region of China (HKSAR) since 1 July 1997, he Basic Law of Hong Kong allows Hong Kong s cours o refer o decisions under he jurisdicion of common law. As repored by La Pora e al. (1997) ha he common law provides sounder legal proecions for minoriy invesors, as in he US and UK. Second, in order o saisfy he needs for lising in Hong Kong and promoe compeiion wih heir inernaional peers, he lised SOEs have been resrucured before hey issue inernaional offering. The ypical resrucuring mehods is o separae producive hear of he SOEs and esablish hem as companies, and leave he oher non-profi making par such as social and ancillary service operaions o he paren company. I is very likely ha here are some dressing-ups for he lised firms during he packaging process. Neverheless, i is expeced ha company performance should improve because of he resrucuring. Finally, he H firms are obliged o provide annual financial repors in accordance wih Hong Kong or inernaional accouning sandards. And all hese firms are required o recrui Hong Kong cerified public accounans for heir audis. I is reasonable o expec he informaion from hese companies o be more reliable han hose from he oher companies in China ha are no lised overseas. Some papers compared H firms wih A firms or B firms wih regard o companies performance, which include Aharony e al. (2000) who examined he earnings paern of 83 newly lised B and H firms in China from 1992 o 1995, and found ha SOE managers have differen incenive and opporuniies for earnings managemen, hey aribued he 50

51 reasons o he firm s relaion wih he governmen and he locaion where is shares are lised; hey repored a saisically significan pos-issue earnings decline for unproeced indusry firms, hey also found ha he H firms exhibi smaller pos-ipo reurn on asses decline han B firms. Wang and Jiang (2004) examined he Chinese companies cross-lised in mainland China (A shares) and Hong Kong (H shares). They documened a large ime-varying H share price discoun relaive o ha of A shares, and hey aribued his discoun o domesic and foreign marke facors and relaive marke illiquidiy. They also repored ha H shares exhibi significan exposure o Hong Kong marke facors and behave more like Hong Kong socks han he mainland Chinese socks. Guo and Tang (2006) compared he price differences beween H and A shares. They found ha he Chinese mainland invesors require lower rae of reurns han foreign invesors, and liquidiy is greaer in he A share marke, which is conrary o he convenional wisdom ha firms cross-lis o achieve lower cos of capial and greaer liquidiy. Their resuls also indicae ha differences in cos of capial and liquidiy beween he wo markes conribue o he price difference beween he Chinese A shares and heir maching H shares. Eun and Huang (2007) sudied asse pricing mechanism of China s sock marke, and revealed domesic A share invesors would value A shares more if here are B and H shares counerpars, which suggesed ha a Chinese firm wih a foreign shareholder base has a lower cos of capial. 2.4 Sock Exchanges, Transacion Coss, and Trading Mechanisms We have analysed he unique characerisics of he Chinese lised firms and he 51

52 segmened sub-markes for A, B and H share holders. O Hara (2001) emphasized he imporance of ha he price discovery and liquidiy are affeced by marke environmen and he characerisics of he firms hemselves. We hen proceed o discuss he marke microsrucure and rading coss of he hree China-relaed sock exchanges. Xu (2000) sudies he microsrucure of he China s sock marke wih regard o he rading mechanisms design, as well as empirically invesigaes rading volume and volailiy relaion of he marke index (Shanghai Composie Index). Our sudy will focus on he impac of he rading mechanisms on he rading coss and liquidiy, because rading coss and liquidiy is criical in deermining socks price discovery and firms lising decision, i would be helpful for undersanding why he Chinese SOEs lising paerns are differen from ha of he privae firms Transacion Coss and Liquidiy Alhough he Shanghai Sock Exchange and he Shenzhen Sock exchange have adoped advanced elecronic rading sysems, i is no guaranee ha he wo sock exchanges will work as efficienly as he sock exchanges in Hong Kong, New York and similar ohers. As menioned by Harris (2003:420) ha Exchanges conduc ransacion cos measuremen sudies o documen he qualiy of heir markes. When we value he efficiency of a sock exchange, one imporan poin ha mus be considered is ransacion coss; because low rading coss helps raders rade efficienly, for example raders can minimize ransacion coss of a given size, or maximize size for a given cos. Transacion coss include all coss associaed wih rading. These coss include 52

53 explici cos, implici cos, and missed rade opporuniy coss (Harry, 2003:421). Explici coss are hose coss which include brokerage fees, exchange charges and he axes applicable on he ransacions when hese are execued. Implici coss such as marke impac coss canno be easily idenified and measured. Marke impac coss usually arise because raders have an impac on prices, especially when a large order is execued in a very shor period of ime. And i is easy o undersand ha he price changes are usually adverse in erms of he iniial rading; for example, selling drives prices down, and vice verse. So he iniiaor has o spend par of his funds under managemen o purchase liquidiy. Missed rade opporuniy coss arise when raders fail o fill heir orders or fail o fill heir orders in a imely manner. Compeiion among brokers o arac large number of invesors ends o decrease he explici coss, as i seems o happen nowadays. However, he implici cos is more or less ou of he invesors conrol, because i depends mainly on he marke condiions. Reducion of he implici cos is a key facor for enhancing he reurns on an invesmen. The facors deermining marke impac coss include he volume of he ransacion, he marke liquidiy, and marke deph. Large volumes of ransacions end o incur large marke impac coss for a given liquidiy condiion, and vice verse. Bu he liquidiy condiion of he marke raher han he size of he ransacion have a greaer influence on marke impac coss. In a highly liquid marke, he bid ask spread can be narrowed down, so even a large volume of ransacion can be easily execued wih lower cos. Marke deph is he size of an order needed o move he marke by a given volume of rade. Parial execuion arises when he deph of a sock marke is no sufficien o complee he ransacion. This will resul in an adverse price movemen, because he remaining par of 53

54 he ransacion has o generae addiional deph on he opposie side, which may resul in a higher (lower) price in buy (sell) Trading mechanisms Madhavan (1992) examined how differen rading mechanisms affec he process of price formaion, and argued he crucial funcion of a rading mechanism is o ransform he laen demands of invesors ino realized ransacions. And no wo rading mechanisms are alike in he performance of price discovery; hey differ in he ypes of orders permied, he imes a which rading can occur, he quaniy and qualiy of marke informaion made available o invesors a he ime of order submission, and he reliance upon marke makers o provide liquidiy. Trading mechanisms can be classified ino coninuous and periodic mechanisms based on he ime a which rading occurs. In a coninuous marke an invesor s order is execued immediaely upon submission, where full ransparency is provided of he limi order book. The periodic sysem (commonly referred o as a call aucion or bach marke) is characerized by a se of mulilaeral ransacions a a given price, where he orders are mached periodically a he mid price of he quoes. The laer sysem doesn provide any independen price discovery mechanism. No single sysem is ideal for a marke. The decision o adop coninuous or periodic call aucion maching depends on he marke dynamics. A marke sysem which prefers greaer ransparency and favors reail invesors would more likely wan o adop a coninuous maching sysem enabling he invesors o view he full limi order book and decide on he price of he insrumen raded. This limi 54

55 order book disclosure may no be favorable for a large insiuional invesor who generally places orders for a large quaniy. Disclosure of full order book will resul in more impac cos for he insiuional invesor. An insiuional invesor would raher prefer o hide is order from he marke and execue a an average price. Normally markes, which operae on coninuous maching sysem, end o adop call aucion mechanism and single price execuion whenever rading is resumed from marke hal. The reason behind his is ha his ype of rading ensures ha he informaion accumulaed during he hal period should be facored in he price of he asse once he rading is resumed from hal. So a brief pre-opening session is held (before he coninuous rading is resumed) o accumulae he orders and orders are execued based on call aucion mechanism. On he oher hand, based on he reliance upon marke makers o provide liquidiy, marke microsrucures may be classified ino quoe-driven (such as NASDAQ) and order-driven rading mechanisms (such as NYSE), In a quoe-driven sysem, invesors can obain firm price quoaions from marke makers prior o order submission. This mechanism is also known as a coninuous dealer marke because an invesor need no wai for order execuion, bu insead rades immediaely wih a marke maker, he marke maker supply all he liquidiy. In pure quoe-driven markes, dealers paricipae in every rade. Anyone who wans o rade mus rade wih a dealer, raders eiher negoiae wih he dealers hemselves, or heir brokers, acing as heir agens. The dealers frequenly rade among hemselves, bu public raders canno rade wih each oher. By conras, in an order-driven sysem, also known as aucion sysem, invesors submi heir orders for execuion hrough an aucion process, order-driven mechanisms 55

56 can operae eiher as coninuous sysems or as periodic sysems, in he firs ype, known as coninuous aucion, invesors submi exising limi orders submied by public invesors or dealers. The sysem is coninuous, since orders are execued upon arrival, bu operaes as an aucion because he price is deermined mulilaerally. The second ype of order-driven sysem is known as periodic aucion, where he orders of invesors are sored for execuion a a single marke clearing price. In order-driven markes, buyers and sellers regularly rade wih each oher wihou he inermediaion of dealers; hese markes have rading rules ha specify how hey arrange heir rades. In order-driven markes, raders can offer or ake liquidiy; raders who offer liquidiy indicae he erms a which hey will rade. Traders who ake liquidiy accep hose erms. Compared o aucion marke (order-driven marke), dealer marke (quoe-driven marke) has more impac on liquidiy, because of narrower spreads in he dealer marke, informed raders are less likely o ake umos advanage of he special informaion ha hey have. The spread also depends on he marke makers invenory as marke makers rade based on heir invenory posiion. A balanced invenory posiion of a marke maker will resul in narrower spreads due o he pressure on he marke maker o mainain his invenory being less. Bu oo many long or shor posiion will resul in high pressure on marke maker s invenory ha resuls in wide spreads in he marke maker quoe. In he following secions, we will conras ransacion coss (explici and implici coss) among hree China-relaed sock exchanges, we also compare his hree sock exchanges by examining he marke condiion including marke size, rading value, rading hours and rading days, and describe he marke mechanisms of each marke, including rading mechanisms, clearing and selemen sysems, and marke maker sysem, 56

57 ec, and he policy ools used by he regulaory auhoriies o conrol marke volailiy, such as shor-selling resricion, daily price limis, and ick size Transacion coss of hree China-relaed sock exchanges As discussed above, ransacion coss include explici coss and implici coss. I is easy o quanify explici coss which mainly ake accoun of brokerage fees, exchange charge and he axes applicable on he ransacion when i is execued. However, i is difficul o accuraely measure implici coss, i.e. marke impac coss and opporuniy coss. Marke impac coss can be explained by rade size, rade direcion (i.e. buys or sells), sock size, invesmen syle, and he ype of insiuion execuing he rade package, and is direcly relaed o he size of he rade execued by an insiuional invesor. Normally larger volume ransacions are expeced o incur higher marke impac coss, he reason is because ha larger rades will accoun for a higher proporion of oal rading volume, and hence he size of an order can cause an adverse shock in he price of sock. Oher implici coss in rading are opporuniy coss incurred by paien raders seeking o avoid marke impac coss (i.e. he value los due o informaion decay). Hence, here exiss a rade-off beween marke impac and opporuniy coss Explici coss of he SHSE (SZSE) and HKSE We summarize explici coss of Shanghai sock exchange (Shenzhen sock exchange), and Hong Kong sock exchange in able 2.5. The wo mainland China s sock exchanges charge he fees in he differen way ha Hong Kong sock exchange does, especially for 57

58 he ransfer fee, wo China s sock exchange charge 0.1% per side of he ransacion value while Hong Kong sock exchange charges HK$2.50 per share, when socks prices are relaively high, he way charging in erms of per share will lead o low ransacion coss. So, i is hard o conclude which marke demand high explici coss. Table 2.5 Explici coss of he SHSE, SZSE and HKSE (2006) Sock Exchange SHSE (SZSE) HKSE Brokerage 0.3%, (minimum RMB 5.00) 0.2% - 0.5%, Samp Duy 0.3% per side of he ransacion value 0.1% per side of he ransacion value Trading Fee N/A 0.005% per side of he ransacion value Transacion Levy N/A 0.004% per side of he ransacion value Transfer fee 0.1% per side of he HK$2.50 per share ransacion value Source: Fac books (2006) of Shanghai Sock Exchange, Shenzhen Sock Exchange, Sock Exchange of Hong Kong Marke impac coss of he SHSE (SZSE) and HKSE Traders esimae marke impac coss by using specified price benchmark mehods and economeric mehods of esimaion of ransacion cos. The price benchmark mehods are he mos commonly used, because hey are easier o implemen han he economeric mehods. So, he esimaed cos would be relaive o rade size and he difference beween rade price and benchmark price (Harris 2003:422). Esimaed Cos = Trade Size * Trade Sign * (Trade Price Benchmark Price) Trade Sign = 1 for a purchase / -1 for a sale The 2006 annual repor by he SHSE research insiuion abou marke qualiy provides a comparison of ransacion coss on he SHSE chronologically as well as comparison of ransacion coss among differen sock markes. They repored he marke 58

59 impac coss on he SHSE based on a ransacion value of RMB 100,000 from 1995 o According o he repor, he basis poin of marke impac coss is on a decreasing rend on boh buy and sells sides (see Table 2.6). This annual repor also compared he marke impac coss on he SHSE for he same ime period when ransacion values are respecively RMB 100,000, RMB 250,000, and RMB 900,000, and found all marke impac coss based on differen levels of ransacion value dropped year by year, bu large value of rades has much higher impac on he ransacion cos (see Table 2.7). Furher, hey compared he marke impac coss on he SHSE, HKSE, NYSE, and NASDAQ, and found ha he SHSE has he highes marke impac cos, while NYSE has he lowes coss (see Table 2.8). Table 2.6 Marke impac coss on he SHSE for one ransacion value (based on a ransacion value of RMB 100,000) Uni: basis poin Buy Sell Table 2.7 Marke impac coss on he SHSE for hree ransacion values (ransacion values are respecively RMB 100,000, RMB 250,000, and RMB 900,000) Uni: basis poin RMB 100, RMB 250, RMB 900, Table 2.8 Marke impac coss on he SHSE, HKSE, NYSE, and NASDAQ Uni: basis poin SHSE SEHK NASDAQ NYSE

60 2.4.4 SHSE, SZSE, and SEHK The marke condiion The SHSE and SZSE have adoped a marke rading sysem based on modern compuerized and elecommunicaions echnology and fully praciced elecronically auomaed rading. The sysem auomaically maches he closes offer and bid and works remarkably well in pracice. Based on he principle of price prioriy and ime prioriy, he sysem offers concenraed bidding and maches offer and bid deal by deal, wih a daily capaciy of 10 million commissions. Mos of he firms lised in he SZSE are small, join venure firms, and since 1994, he SZSE has been over aken by he SHSE in erms of marke capializaion, rading volume, and number of lised shares (Xu, 2000). Recenly, he governmen has decided o merge he SHSE and SZSE ino an inegraed main board marke. The lised companies on he main board of he SZSE will move o he SHSE in wo o hree years ime, while he SZSE will be dedicaed o Growh Enerprise Marke. The Chinese auhoriies have realized ha sock exchanges around he world are rushing o esablish alliances and parnerships wih one anoher ha could lead o ourigh mergers and acquisiions. An aricle in Asia Times (June 30, 2007) poined ou ha This cooperaion beween wo Asian bourses has given a renewed impeus o he idea of creaing a link beween he Hong Kong Sock Exchange (HKSE) and he Shanghai and Shenzhen exchanges as many mainland companies are lised on boh bourses. The Sock Exchange of Hong Kong (SEHK) ranks fifh in he world in erms of marke capializaion of lised companies (2006), and is classified by he Inernaional 60

61 Finance Corporaion (IFC) and World Bank as a developed marke. Hong Kong is a free marke economy wih well esablished regulaions for finance and commerce. Non-residens can efficienly rade in Hong Kong sock exchange. Hong Kong dollar is inernaionally exchangeable a a sable fixed rae agains he US dollar (1USD= 7.8 HKD). The hisory of he securiies exchange of Hong Kong began in he lae 19h cenury. The exchange has predominanly been he main exchange for Hong Kong despie co-exising wih oher exchanges a differen poins in ime. Afer a series of complex mergers and acquisiions, HKSE remains o be he core. In 1993 he exchange launched an Auomaic Order Maching and Execuion Sysem (AMS) ha was replaced by he hird generaion sysem (AMS/3) in Ocober These sysems were added o mee he increased populariy of online sock rading Trading hours and rading days The SZSE and SHSE open from 9:30 am o 15:00 pm wih a lunch break from 11:30 am o 13:00 pm. There is a pre-rading session from 9:15 am o 9:25 am each day; he morning opening prices are generaed during ha session. Thus we see a hybrid of periodic aucion and coninuous aucion rading mechanism in he wo markes under discussion; he periodic aucion is used once a day o generae he opening price. During he res of he rading ime, coninuous aucion is used o mach ransacions. They open 5 days a week excep for holidays; he SZSE has more holidays han he SHSE during he Chinese New Year period, and boh exchanges have fewer rading days han he SEHK. 3 More informaion can be found in HKEx websie, hp:// 61

62 The SEHK opens 5 days per week, and he rading hours is from 10:00 am o 12:30 pm and from 14:30 pm o 16:00 pm. Like sock markes in mos counries and economies in Asia, he SEHK has adoped a coninuous aucion marke microsrucure. Table2.9 Marke condiion, Trading hours and Trading days (SHSE, SZSE, and HKSE, 2006) Sock exchange SHSE SZSE HKSE Number of lised firms (including domesic and foreign firms) Marke capializaion , (US $ billions) Marke capializaion of radable shares (US $ billions) % 34.19% 8.50% 115% (Marke capializaion/gdp) % 7.85% 4.10% - (Tradable Marke capializaion/gdp) Trading value , (US $ billions) % 80.74% % 62.89% (Trading value/toal marke capializaion) % 351.9% % - (rading value/radable marke capializaion) P/E raio Dividends yield Trading hours 9:30-11:30 13:00-15:00 9:30-11:30 13:00-15:00 10:00-12:30 14:30-16:00 Trading days Source: Fac book of each sock exchange, Marke capializaion and Trading value include A and B shares only 3. In 2005, China adoped floaing exchange rae, according o hp:// he average exchange rae of USD o RMB in 2006 is 1USD=7.97RMB, and we conver RMB o USD a a yearly average exchange rae. Hong Kong has been pegged is exchange rae o USD a 1USD=7.8 HKD since China and Hong Kong are in he same ime zone Trading mechanisms 62

63 Firs, like many oher maure markes employing muliple rading mechanisms (for example he NYSE and NASDAQ are boh hybrids of dealer marke and aucion marke), he wo young Chinese mainland exchanges are hybrids of periodic aucion (9:15am- 9:25am of every rading day) and coninuous aucion (9:30am-15:00am of every rading day). During he periodic aucion, all orders are mached on he basis of price prioriy, while during he period of coninuous aucion; all orders are mached according o he principle of price as well as ime prioriy. The periodic aucion applies once per day o deermine he morning opening prices. All bidding orders are se from high o low, and all asking orders are se from low o high, he final execuion prices ge deermined beween he highes bidding price and he lowes asking prices and as many as pre-rading orders as possible are execued. The coninuous aucion is used during he res of he rading hours in erms of ime and price prioriy, so ha each ransacion price is he equilibrium price deermined by he demand for and supply of securiies a each spo of ime. Compared o periodic aucion, marke volailiy ends o be higher in coninuous aucion. In Hong Kong, he coninuous aucion mehod is used hroughou he rading day and also deermines opening and closing prices Clearing and selemen sysems The regisraion and clearing of securiies is cenralized hrough he China Securiies Deposiory and Clearing Corporaion Ld. (CSDCC). Before rading in a sock exchange, an invesor mus place all he securiies (fully demaerialized) ino an accoun opened wih he CSDCC. Currenly, he selemen for A shares is T+1 and he selemen for B 63

64 shares is T+3. (Nefci and Menager-Xu, 2007:15) The China Securiies Deposiory and Clearing Corporaion (CSDCC) is he only securiies deposiory and clearing corporaion regisered wih he Sae Adminisraion of Indusry and Commerce in compliance wih he Securiies Law of he People's Republic of China and he Company Law of he People's Republic of China. CSDCC is based in Beijing wih subsidiaries in Shanghai and Shenzhen. I operaes under he supervision of he China Securiies Regulaory Commiee (CSRC). CSDCC was founded on March 20, 2001, wih he approval of he Sae Council and CSRC. (hp:// The Hong Kong Securiies Clearing Co Ld (HKSCC) is he clearing company for ransacions relaing o socks and a variey of oher SEHK-raded securiies, raded-opions on he SEHK. The HKSCC sared o operae on May 28, 1992, and he selemen period is T Floor based rading vs. Auomaed rading sysem Unlike he NYSE, he wo exchanges in China have almos no floor raders or floor brokers; buy and sell orders are mached hrough a elecommunicaions nework bu no on he acual rading floor. Elecronic rading sysem is now widely used around he world which differs from he radiional rading mehods such as floor rading in several ways. The mos marked advanage of elecronic rading sysem is ha i helps o improve marke liquidiy by reducing bid-ask spreads; however, when rading volume increases a imes of marke sress, i underperforms a floor-based rading sysem by widening he bid-ask spread. As Soll (1992) poined ou, here are disadvanages of an auomaed 64

65 sysem which affec several aspecs of marke srucure such as risk bearing, free rading opions, informaional rading, repuaion building, and anonymiy. Venkaaraman (2001) also menioned ha insiuional invesors prefer o use he floor broker o work large and difficul orders. This is because he floor brokers can reduce marke impac and execuion coss by reacing quickly o he changes in he marke condiions and execue sophisicaed rading sraegies. Hong Kong abandoned floor rading sysem since 1993 when Auomaic Order Maching and Execuion Sysem (AMS) replaced he radiional rading sysem. (McGuinness, 2000:85) Marke marker sysem There is no official marke marker sysem in SZSE and SHSE. Marke makers, also known as specialiss in he NYSE, provide liquidiy on demand in small quaniies. They ofen rade in and ou of heir posiions many imes a day. (Harris, 2003:195) Marke maker sysem is helpful in promoing marke liquidiy and he deph of marke. Anoher imporan role of he marke makers is o sabilize sock prices. Marke makers have heir own invenory posiion; hey mus adjus purchasing and selling ou of heir own invenory o balance he marke when here's a demand-supply imbalance of a paricular securiy. The lack of official marke maker sysem in he SZSE and SHSE could be a main reason for he wo exchanges o have low liquidiy (measured by he bid ask spread) and high ransacion cos. (Shanghai Sock Exchange Trading Qualiy Repor, 2006, in Chinese language) 65

66 On he SEHK, he number of marke maker is 21 by he end of 2006 (SEHK Fac book, 2006), since SEHK employs elecronic maching sysem, marke makers are only required o quoe wo way prices a specified imes o enhance liquidiy of he markes. Comparing wih he NYSE and NASDAQ, we can find ou one of he disincive characerisics of he hree China-relaed sock exchanges is ha, he block rading in hose hree exchanges are very limied because block rading are normally execued by marke makers, however, block rading in he US sock marke accoun for abou 50% of daily rading, herefore, we can clearly see he big difference in he rading coss and liquidiy among hese markes Over-The-Couner (OTC) Marke Unlike he US where a mulilevel financial rading sysem has been buil up, China has only wo naional sock exchanges and no sock exchange a he provincial level. The Chinese auhoriy had launched wo OTC markes in he lae of 1980s wih only very limied informal exchanges and rading, however, due o lack of effecive supervision and regulaion, hese wo markes were closed in 1999, and he decision o re-open hese is sill under discussion Shor selling pracice Shor-selling pracice is quie popular in he developed sock markes, especially in he 66

67 US markes, which is an invesmen sraegy used by speculaive invesors who ry o profi from he falling price of a sock. Shor-sellers usually borrow a securiy (or commodiy fuures conrac) from a broker before selling i, wih he undersanding ha i mus laer be bough back (hopefully a a lower price) and reurned o he broker. The wo Chinese exchanges have sric resricion on shor-selling, while Hong Kong has relaxed he resricions on shor-sells gradually since 1994, when 17 designaed securiies could be sold shor in a pilo scheme. The number of hese designaed securiies has increased over ime and a presen; here are 527 securiies eligible for shor-selling according o he official websie ( Tick size Mos sock exchanges have regulaions on ick size which is minimum allowable price movemen. Tick size is one of he facors aribuing o affec marke liquidiy, if he size is oo large; raders are relucan o improve prices because of he expense involved. The Sock Exchange of Hong Kong (SEHK) has differen levels on ick size according o differen scales of sock price, for example, when sock price is beween HK$ 0.01 o HK$ 0.25, he ick size is HK$ 0.001, when sock price is beween HK$ 0.25 o HK$ 0.50, he ick size is HK$ On he SZSE and SHSE, he ick size for quoes on A shares is RMB 0.01yuan. Huang and Soll (2001) repored in heir empirical sudy on he socks raded on he London Sock Exchange (LSE) and heir respecive ADRs raded on he NYSE, ha he lower resricions on ick size will cause he higher spreads, higher quoe 4 hp:// 67

68 clusering and higher marke deph Daily price limis Boh SHSE and SZSE applies a 10% price cap for boh rise and fall margins wihin he day for shares and funds rading o mainain marke sabiliy and keep away from dramaic flucuaions in share prices. However here is no limi imposed on he HKSE Conclusions We have sudied he feaures of he hree componens of he domesic marke, he lised firms, he invesors, and he sock exchanges. Wih regard o he lised firms, we analyzed he roo of he ownership srucure problems. Afer an inroducory survey of he hisorical moivaions of he Chinese governmen o creae he sock marke and enlis he SOEs, we concluded ha he sae owned non-radable shares of he lised firms have been an obsacle for he developmen of China s sock marke and he performance of he lised firms. We hen focused on he imporan non-radable shares reformaion which sared from 2002; he reform policies and he impac on he marke were reviewed. Wih respec o he invesors, we have shown how he invesors were arificially grouped ino hree segmened sub-markes, he A shares, B shares, and H shares sub-markes. We have also reviewed he lieraure sudying he price discoun puzzle ha 5 On he NYSE, he ick size was US$ before June 24, 1997, and has been US$ since hen unil 2000, when he size was decreased o US$ However, here is no limis on ick size on he LSE 68

69 addressed ha he A shares prices have been much higher han he prices of B shares and H shares. By reviewing he imporan published papers abou his issue, we have made he following conclusions; firs of all, he B shares lising do no make any conribuions o he lised firms o improve heir operaion, even hough B shares were iniially issued only o he foreign invesors. Unlike he firms issuing A and B shares, he firms wih H shares lised in Hong Kong behave more like he Hong Kong firms raher han like he mainland Chinese firms, in erms of informaion disclosure, corporae governance, and firms performance. We also examined he impacs of imporan policy changes which aimed o gradually release he segmenaion resricions among hese hree sub-markes. For he sock exchanges, we have sudied he rading mechanisms and marke microsrucure of he hree China-relaed exchanges. We compared explici rading coss and implici rading coss, wherever applicable, and conrased hem wih he coss of he NYSE and NASDAQ. We repored ha he explici coss of China s domesic sock exchanges are no demonsrably higher han ha of he Hong Kong sock exchange, ye, he implici rading coss of wo domesic sock exchanges are exremely higher han hose of he Hong Kong sock exchange and boh he NYSE, and NASDAQ. Furher, we compared he marke capializaion, he value of rading volume and urnover raio of he hree China-relaed sock exchanges; we found he domesic sock marke has exremely small marke size and paricularly high urnover raio, especially when we have o ake accoun of he radable shares. These findings may give he answers o he quesions we asked in he beginning ha wheher he reason for he Chinese governmen o lis he imporan SOEs abroad is o gain he benefi of capial raising and more liquid rading. As well as wheher he Chinese privae firms are more sensiive abou he lising coss han 69

70 he Chinese SOEs so ha he privae firms choose o regiser in some ax-free islands before hey lis in he NASDAQ. 70

71 Chaper 3 Lieraure Review on ADRs and Relaed Topics 3.1 Inroducion This chaper presens a comprehensive lieraure review abou he main issues abou ADRs. In chaper 1, we have explained he reason o selec he Chinese ADRs as our research objec is because of he special characerisics of he Chinese ADRs ha hey connec hree markes. An explici connecion beween he US and Hong Kong marke is obvious due o he ransmission mechanism beween he Chinese ADRs and he underlying H shares. In addiion, due o he fac ha par of hese Chinese ADRs lis A shares (only owned by he Chinese ciizens) in Shanghai afer hey lis H shares and ADRs (only owned by foreign invesors), here is also an implici connecion exising beween he China s marke and he US and Hong Kong marke, such kind of marke linkage supplies a closer examinaion on he available heories and hypoheses pu forward in he ADRs lieraure. We organize his chaper as: secion 3.2 is an inroducion abou he background of he ADRs; secion 3.3 conains an ouline of he moivaions for cross-lising based on he poin of view of he firms; secion 3.4 is a lieraure of he issues relaed wih price discovery hypohesis, he relaed heories include he segmened marke hypohesis and he cos of capial of he cross-lising; secion 3.5 is a lieraure abou he ADRs arbirage and he limis of he ADRs arbirage; secion 3.6 reviews he lieraure of liquidiy effec and he liquidiy effec on he cross-lised securiies; finally, secion 3.7 is conclusion. 71

72 3.2 American Deposiory Receips (ADRs) An ADR is a negoiable insrumen issued by a US deposiary bank evidencing ownership of shares in a non-us corporaion. Each DR denoes Deposiary Shares (DSs) represening a specific number of underlying shares on deposi wih a cusodian in he issuer s home marke. The erm DR is commonly used o mean boh he physical cerificae and he securiy iself. There are mainly hree levels of ADRs based on differen accouning sandards and Securiies and Exchange Commission (SEC) disclosure requiremens. The Level I Deposiary Receips are raded in he US Over-The-Couner (OTC) marke wih prices published in he Pink Shees and on some exchanges ouside he Unied Saes. The Level II and Level III Deposiary Receips are exchange-lised securiies and raded on NASDAQ, AMEX or NYSE and have more sringen accouning and disclosure requiremens. 6 Prior o 1990, mos ADRs were of companies from developed couriers, such as he UK, Ausralia, and Japan. However since 1990, more and more firms from emerging counries such as Chile, Mexico, Brazil, India and China have sared issuing ADRs and accouned for one hird of he oal ADRs in circulaion a he end of 1990s. Developed counry firms have hisorically used ADRs for overseas lising, bu mos emerging counry firms issue ADRs o raise sufficien capial from he US marke (Gande, 1997). One paricular aspec of he ADRs is ha he ADR owners can conver he shares ino he foreign currency-denominaed underlying shares subjec o cancellaion and conversion fees. By he same oken, holders of he underlying shares can conver heir shares ino ADRs if hey are raded in he US markes (Kim e al. 2000). Therefore, an 6 A deailed inroducion on ADRs can refer o he survey paper by Karolyi (1998) 72

73 invesor who compares he ADR price wih he dollar price of he underlying share can ge a risk less profi if he price differenial is sufficien o cover he ransacions coss. 3.3 Firms moivaions for cross lising The firms moivaions for cross-lising in he lieraure are sraighforward because of he obvious evidence. In conclusion, he moivaions of he non-us firms o cross lis in he US marke are governed by a) increased rading liquidiy (Mioo, 1992; Pagano e al., 2002; Rabinovich e al, 2003); b) promoing firms visibiliy, exposure, and presige (Fano and Karmel, 1997); c) reducion in marke segmenaion and he aendan cos of capial, increase invesor recogniion, enhance liquidiy and bond hemselves o proec he minoriy shareholders (Errunza and Miller, 2003). The above percepions abou overseas lisings show ha overseas lisings should have posiive impac on domesic firms achieving a fair valuaion by improving he rading efficiency of heir shares lised on he domesic sock exchanges. 3.4 Price discovery process of he ADRs The lieraure abou he price discovery on he ADRs conains several relaed heories or hypoheses, which include he segmened markes hypohesis, price discovery heory, and he cos of capial. A prevailing wisdom abou he US-lised non-us shares is ha cross-lising would decrease he sysemaic risk of capial caused by segmenaion. The segmened markes hypohesis mainains ha due o some direc inernaional invesmen 73

74 resricions, such as ownership resricions and invesmen barriers are erased by cross-lising in a less-resriced marke, he compensaion for he local invesors inabiliy o diversify heir invesmens globally would disappear. So cross-lising would decrease he cos of capial, and ask for a higher equilibrium marke price, a lower sysemaic risk, and hus a lower securiies reurn. One of he relaed research quesions is in which marke price discovery akes place, he home or he off-shore marke? Price discovery is defined as he search for an equilibrium price and is a cenral funcion of a sock exchange. Researchers find ha he shares cross-lised in he inegraed markes have differen price discovery process wih hose cross-lised in he segmened markes. In his secion, we review he papers relaed wih he hree issues discussed above, he segmened markes hypohesis, he cos of capial, and he price discovery heory. Alhough some earlier papers we will review in his secion are no exclusively abou he ADRs, hese papers offered empirical sudy approaches which have been applied laer on in he ADRs sudies The segmened marke hypohesis The sudy abou he inernaional capial markes segmenaion and inegraion sars from Sapleon and Subrahmanyam (1977), Errunza and Losq (1985), and Alexander, Eun, and Janakiramanan (1987). These papers considered a number of invesmen barriers in he inernaional capial marke. Sapleon and Subrahmanyam (1977) considered wo ypes of segmenaions; one 74

75 is caused by resricions on cerain individuals invesing in cerain securiies and is exemplified by segmenaion in inernaional capial markes; and he second one is induced by he simulaneous exisence of differenial personal ax raes and a fixed elemen of ransacions coss. They buil up a Walrasian equilibrium model on he framework of single period capial asse pricing model (CAPM). Their models confirmed he pronounced effec of hree financial policies as he firm s inenion o remove invesmen barriers. The hree financial policies include Foreign porfolio/direc invesmen by firms, mergers wih foreign firms, and dual lising of he securiies of he firm on foreign capial markes. They also confirmed a srong negaive ax effec of dividend policy ha affec invesors porfolio selecion. An invesor can gain he advanages of he ax characerisics of he socks by going long in hose ha sui his ax bracke and shor in hose ha do no. Alexander, Eun, and Janakiramanan (1987) considered a siuaion ha one of he domesic securiies is dually lised on a foreign capial marke, while none of he foreign securiies is dually lised on he domesic capial marke. The domesic marke is assumed o be wih relaively limied capial or a relaively underdeveloped capial marke and wih resricion on is ciizens o inves in foreign securiies. The scenario of heir model was ha dual-lising would remove a variey of invesmen barriers such as ransacion coss, informaion coss, and legal resricions on domesic invesors o inves overseas. Their model clearly indicaed ha he expeced reurn on he dually lised securiy was differen from is expeced reurn when i is no dually lised. The revaluaion of he change in he reurn afer dual-lising depends on he risk premium measured as he relaive covariance of he dually lised securiy wih he domesic and foreign marke 75

76 porfolios. Their model prediced ha dual-lising would lead o a higher marke price and a lower required reurn due o he decrease in he risk. Errunza and Losq (1985) proposed Mild Segmenaion Hypohesis and conduced empirical invesigaion of he pricing (and porfolio) implicaions of invesmen barriers in he conex of inernaional capial marke. The scenario of heir model is parial segmenaion ha in a wo-counry capial marke where counry 1 invesors are resriced, counry 2 invesors are unresriced. Unresriced invesors can rade in all he securiies available; while he resriced invesors, can rade only in a subse of he securiies, hose which are ermed eligible. Their hypohesis was he ineligible securiies command a super risk premium which is proporional o he condiional marke risk, and hey found supporive hough no srong evidence in he less developed counries. Apar from he segmenaion which comprises he direc inernaional barriers caused by regulaory fricions, here are some specific paerns of segmenaion which may no be observed direcly. For example, Foreser and Karolyi (1993) defined indusry segmenaion as indusry relaed segmenaion even when wo markes share high degree of connecion in business, culure and geography such as Canada and he US. Paricularly, wih respec o ADRs rading, differen rading hours is anoher imporan facor of segmenaion. The ADRs are in principle fully converible ino heir underlying socks, however in pracice hese are impossible when he wo markes have few overlapping rading hours even when hese wo markes are inegraed according o he prevailing definiion. Karolyi (1998) menioned non-synchronous business and rading hours will increase he coss of informaion monioring, which he described as an 76

77 indirec inernaional barriers. Similarly, Kao e al (1991) and Kim e al. (2000) menioned he imporance o ake ino accoun he non-synchronous rading hours in he sudy of he arbirage of he ADRs, as which may make arbirage beween ADRs and heir underlying shares cosly The cos of capial The segmened markes hypohesis is he heoreical background of he issues of he cos of capial and price discovery. As we have discussed in he beginning of his secion, here is growing evidence ha he cos of capial change around cross-lising dae due o he inernaional invesmen barriers erased, and we will review papers which are specifically wihin he conex of he ADRs. The imporan papers include Sundaram and Logue (1996), Foerser and Karolyi (1999), and Bekaer and Harvey (2000). Typically, hese papers measure he change in sysemaic marke risk (wih facor models, such as CAPM and APT), as well as he change in oal risk (ex pos sandard deviaions of reurns, or ex ane implied volailiies from opions) in a specific ime period around overseas lising dae. Sundaram and Logue (1996) examined he change of he cos of capial for 76 ADRs from 1982 o 1992, hey evaluaed hree coss: he price-o-book value, price-o-cash-earnings, and price-o-earnings, by adjusing he home and world counry indusry indices. They found he price raios increased associaed wih he cross-border lising, and hey aribue he reason as he reducing of he overall effec of segmenaion among differen markes. Foerser and Karolyi (1999) sudied 153 ADRs from 1976 o 1992, and idenified 77

78 he imporan changes in he sock reurn ha non-us firms earn cumulaive abnormal reurns of 19 percen during he year before lising he ADRs, and earn addiional 1.20 percen during he lising week, bu lose 14 percen during he year following lising. They found supporive evidence for hree hypoheses: segmened markes hypohesis, invesor recogniion hypohesis, and liquidiy hypohesis. Errunza and Miller (2000) presened evidence on liberalizaion's impac on cos of capial and is relaion o he firm's diversificaion poenial, as well as he revaluaion effec. Their sample conained he ADRs from 126 socks from 32 counries over he period They documened a significan decline of 42% in he cos of capial, as well as posiive reurns up o and including he announcemen of he liberalizaion (six o one monh prior o liberalizaion and he monh of announcemen) ha are consisen wih equiy valuaions increasing as he cos of capial falls The price discovery Finally, he invesigaion on price discovery sars from he seminal papers by Hasbrouck (1995), as well as Harris e al. (1995, 2002). Hasbrouck (1995) addressed he quesion ha for he homogeneous or closely-relaed socks raded in muliple markes, in which marke he price discovery occurs. He employed an economeric approach ha has been largely used in he muli-marke rading sudies aferwards. The basic idea of his paper is he prices of he same asse in differen markes should end o converge in he long run, while in he shor run, hese prices may deviae from each oher due o rading fricions. He used variance 78

79 decomposiion analysis, and named he componens of he variance as informaion share, namely IS model. He found supporive evidence ha he preponderance of price discovery ake place on he NYSE. On he oher hand, Harris e al. (1995, 2002) used he common facor error correcion model o measure how much prices in differen markes adjus due o cross-marke informaion flow. They developed heir model based on he paper of Engle and Granger (1987), which inroduced he concep of error correcion ha described he coinegraed series move ogeher hrough ime, i.e., given movemen away from long-run coinegraion equilibrium in one period, a proporion of he disequilibrium is correced in he nex period. So, Harris e al (1995, 2002) conduced he model by employing a vecor of n componen ime series o represen a common bu exogenous facor of he coinegraed series. The coinegraing vecors define he long-run equilibrium, while he error correcion dynamics characerize he price discovery process. They also conduced empirical invesigaion on he sock IBM based on inraday daa, and found consisen findings ha he NYSE sands for he predominan marke in he funcion of price discovery during mos of he ime period. However, recen empirical sudies, reviewed bellow, on he price discovery of non-us firms lised on he NYSE give inconsisen evidence, and he difference may be caused by he links of he domesic and he US markes in erms of rading hours. The markes wih non-synchronous rading hours, he markes wih several overlapping rading hours, and he markes wih enirely overlapping hours have differen paerns in he price discovery process. For insance, Kim e al. (2000) examined he impac of he underlying shares, he 79

80 exchange rae, and he US marke index on he ADRs prices, heir sample was composed of 21 Japanese, 21 Briish, 5 Duch, 5 Swedish, and 4 Ausralian firms from he period January 1988 o December By esimaing VAR models and analyzing impulse response funcions, hey found ha he underlying shares appear o be mos imporan, bu here is a significan independen role for he exchange rae and he US marke index in pricing ADRs. While heir paper did no specifically address he quesion of price discovery, heir findings of a role for he US facors sugges a more deailed analysis in erms of he issue of price discovery of he ADRs. Eun and Sabherwal (2003) sudied 62 Canadian firms cross-lised in he US, by applying he error correcion model as Harris e al. (1995) and invesigaing he inraday price for a six-monh period, hey also performed cross-secion regression analysis o sudy he facors which migh aribue o price discovery, such as rading volume in he US, rading coss of he US, and proporion of he shares raded in he US, hey repored ha for a majoriy of socks, price discovery ook place in he US, and he greaer he proporion of shares raded in he US, he greaer he U.S. conribuion o price discovery On he oher hand, he sudies of he US-lised European socks ell a differen sory, since here are only couple of overlapping rading hours beween he NYSE and he European sock exchanges. Gramming e al. (2000) examined he inraday daa for hree US-lised German firms (wih hree overlapping hours beween he NYSE and he Frankfur Sock Exchange) for hree monhs; hey found he Frankfur Sock Exchange dominaed over he NYSE in price discovery only during he hree overlapping rading hours. Pascual e al. (2001) examined five Spanish socks lised in he US by using similar approaches as Gramming e al. (2000), and repored he conribuion of he NYSE 80

81 is less han 3.5%. Furhermore, for he cross-lised Asian socks, Kadapakkam e al. (2003) examined 23 Indian Global Deposiory Receips (GDRs) which are same in oher erms as he ADRs excep ha he GDRs are lised in London (wih hree overlapping rading hours beween he London and Mumbai sock exchanges), by using he approach as Hasbrouck (1995), hey found ha boh markes conribue equally o he price discovery, and he conribuing of he off-shore marke o price discovery increase wih he foreign ownership and he issue size of he Global Deposiory Receips. In paricular, Xu and Fung (2002) sudied 10 Chinese ADRs 7 during he ime period from January 1994 o May This paper examined he ransmission of pricing informaion for dual-lised socks in domesic (Hong Kong) and offshore (he US) markes, and repored Hong Kong had more imporan role of price discovery han he US. 3.5 Arbirage opporuniy and he limis of arbirage The mos exensive and aracive research on he ADRs is in he area of deermining he exisence and exen of he ADRs premium, and he reasons why arbirageurs are impeded o eliminae he price deviaion beween he ADRs and heir counerpars. An ADR represens he underlying shares (raded in home marke) in he foreign (hos) marke and hence boh securiies have he same sae coningen payoffs. Thus assuming boh hos and home markes are efficien and inegraed, by virue of he law of one price, 7 These 10 Chinese ADRs have been included in our sample, excep he ADRs have been erminaed lising. 81

82 he ADRs and heir underlying securiies should have idenical prices afer adjusing for he exchange raes. Hence deviaions from he law of one price indicae arbirage opporuniies. Arbirage is a concep cenral o he heory of capial markes, which is defined as he ac of buying an asse a once price and simulaneously selling i or is equivalen a a higher price (Bodie, Kane and Marcus, 1996:133). Theoreically, i is a zero-risk and needs zero-ne invesmen sraegy ha sill generaes profis (Bodie, Kane and Marcus, 1996:965). Bu, in realiy, here usually exis some impedimens o increase he uncerainy for he arbirageurs wih limied horizons. As we have discussed in he previous secion, he lieraure of he segmened marke hypohesis has inroduced he main facors of inernaional barriers, for insance, he explici marke fricions such as ransacions coss, axes, resricion on regulaion ec, as well as he barriers due o he imperfec informaion which are ofen implici and more difficul o observe. In his secion, we will review wo opics, arbirage of he ADRs, and he limis of arbirage of he ADRs which explains why mispricing persiss in an exended period Arbirage possibiliy The research upon he arbirage possibiliy of he ADRs sared from Rosenhal (1983), who examined weekly daa of 54 socks from , by esing serial correlaion beween he ADRs and heir underlying shares, Rosenhal found ha ADR prices are fairly consisen wih weak-form efficiency, as abnormal reurns canno be earned from any price dependence. Kao e al. (1990) examined daily price difference of he ADRs and heir 82

83 underlying shares from Ausralia, England, and Japan from 1986 o 1988, and repored ha here are no significan differences beween he prices of ADRs and ha of heir respecive underlying shares and hence here are no obvious profiable arbirage opporuniies beween any of hese hree markes and he US marke. They also run serial correlaion es on he reurn of he ADRs pariy, and repored significan bu no high correlaion.. However hese research have some limiaions ha he saisical ess employed in heir papers, such as es and Wilcoxon signed-rank es, are well known as only being sensiive in he locaion of disribuion. Furher, he correlaion ess employed in hese sudies canno uncover a dynamic relaionship beween wo securiies, however, i has been recenly documened ha he correlaion beween dual-lised socks changes over ime (Karolyi and Sulz, 1996). Similar findings also include Officer and Hoffmeiser (1987), who examined monhly daa of 20 NYESE lised ADRs and 25 NASDAQ lised ADRs from 1973 o 1983, and consruced porfolios of ADRs wih he domesic socks, and repored ha he ADRs were he subsiues for he underlying shares in erms of diversificaion effec. Miller and Morey (1996) chose one UK ADR as objecive o sudy if he markes are efficien in erms of arbirage opporuniies by employing inraday daa during he period of March o May The auhors calculaed he price difference beween ADR and he UK share afer adjusing for he exchange rae, and repored he mean of he price difference were well wihin he ransacion coss of arbirage. However, one excepion among hose early sudies is Wahab e al. (1992), who examined daily reurn of 31 pairs of he ADRs from eigh counries (he UK, Japan, Germany, France, Sweden, Norway, Ausralia and Souh Africa) in a ime period of 1988 o They consruced porfolios by wo ways, equally weighed and mean-variance 83

84 weighed, and found limied arbirage profi ranging beween 1.23% and 4.44% by consrucing porfolios wih mean variance efficien weigh, bu no profis were found wih equally weighed porfolios. Anoher imporan finding is by Rabinovich e al (2003; hey compared disribuion of he reurns of he ADRs and heir underlying shares, among hem, six ADRs are from Argenina while foureen ADRs are from Chile, and heir sample ime period was from 1993 hrough They found ha he reurns disribuions of he Chilean ADRs are significanly differen from hose of he underlying Chilean shares while he disribuions of he reurns on he Argeninean ADRs and hose of heir respecive underlying shares are similar. They aribued he difference beween Chile and Argenina ADRs o he resricions on foreign invesmen as well as a flexible exchange rae in Chile and no Argenina. They hypohesized ha ransacions coss and marke microsrucure consideraions may explain he differences beween reurns of ADRs and heir underlying securiies in some cases, where hey exis. Anoher ineresing recen paper is by Hong and Susmel (2003) who presened significan arbirage profi by employing pairs-rading in 64 Asian ADRs; hey developed ADRs porfolios by aking long-shor rading sraegy, which is basically o ake long posiion in underlying shares and shor in ADRs when he price difference (ADRs price underlying shares price) is greaer han a posiive value (depends on he arbirage cos). The annual arbirage profi repored in heir paper was up o 33% The limis of arbirage 84

85 The sudy on he limis of arbirage sared from he sudy on he dually-lised company (DLC, also referred o as a Siamese win 8 ), for example, Froo and Dabora (1999), and De Jong e al. (2004). Froo and Dabora (1999) examined he Anglo-American DLC Smihkline Beecham; hey found ha significan mispricing in hese DLCs has exised over a long period of ime. By invesigaing some fundamenal facors, such as he issues relaed o currency risk, governance srucures, legal conracs, as well as he counry-specific senimen, such as he local marke behavior, hey discovered ha fundamenal facors canno explain he price deviaions, however he comovemen wih local sock marke indices could explain par of he ime-series paern in he relaive reurns of he win socks. De Jong e al. (2004) used similar empirical approach as Froo and Dabora (1999) o sudy 12 DLCs. They also found large deviaions from heoreical price pariy for all 12 DLCs. And in line wih Froo and Dabora (1999), hey demonsraed ha mispricing can be fairly explained by comovemen of he prices of win socks wih domesic sock marke indices. For all DLCs, he relaive price of a win rises (falls) when heir domesic marke rises (falls). This finding is consisen wih he view ha noise raders affec he relaive pricing of DLCs. Laer on, Gagnon and Karolyi (2004) applied he same mehodology o he empirical sudy on he arbirage of he ADRs. They also found srong evidence of he price deviaions for many of he almos 600 pairs of cross-lised shares from he 39 counries. Their findings suppored he resuls of he previous works in DLCs ha mispricing exiss due o he comovemen wih he domesic marke indices, however, hey in addiion found ha reurns 8 The wo eldes wins are he Anglo-Duch combinaions Royal Duch/Shell and Unilever NV/PLC. Exensive descripions of hese wins can be found in Rosenhal and Young (1990) and Froo and Dabora (1999) 85

86 on cross-lised socks have significanly higher sysemaic comovemen wih he US marke index and significanly lower sysemaic comovemen wih home marke index han heir equivalen home-marke shares. The comovemen effec indicaed in hose papers (Froo and Dabora (1999), De Jong e al. (2004), and Gagnon and Karolyi (2004)) can be inerpreed as evidence of counry-specific senimen, namely noise rader risk. As Gagnon and Karolyi (2004) have explained in heir paper ha arbirageurs are specialized professional porfolio managers, who are risk-averse and concerned abou he shor-erm performance of he fund, while noise raders are idiosyncraic, who ac on heir erroneous sochasic beliefs. The unpredicabiliy of noise raders beliefs increase he uncerainy and risk of he expeced price of he socks, so he professional arbirageurs usually wih shor horizons would raher wai oher han be agains noise raders o pu on an arbirage rade, herefore, which leads he prices o deviae from heir fundamenal value for an exended period of ime. Apar from he comovemen effec, Gagnon and Karolyi (2004) also suggesed he rade-based barriers, namely, illiquidiy effec is one of oher reasons o pu off arbirageurs. Recenly, some scholars have applied he heory of liquidiy effec developed by Amihud and Mendelson (1986), and O Hara (2003), o sudy he liquidiy and premium beween he cross-lised shares, for insance, Chan e al. (2007), and Guo and Tang (2006). An explici evidence of he relaion beween he ADRs price premium and liquidiy is from one recen paper by Chan e al. (2008). They invesigaed he cross-secional relaionship beween he ADRs premium and he liquidiy of he ADRs and ha of heir underlying shares, heir sample consised of 401 ADRs from 23 counries over he period beween January 1981 and December They employed hree 86

87 liquidiy proxies, namely, Amihud Illiquidiy 9 (Amihud, 2002), urnover raio, and rading infrequency. However, hey also emphasized heir awareness of he difference beween liquidiy level and liquidiy risk, as saed in heir paper ha The level of liquidiy is he predicable par of he radabiliy of he securiy wihou suffering he adverse consequences of marke impac. Liquidiy risk, on he oher hand, arises from he unpredicable changes in liquidiy over ime. They only focused on he effec of liquidiy level, and repored ha he liquidiy effecs remain srong afer conrolling for firm size and a number of counry characerisics. Alhough i is no specifically abou he ADRs, anoher recen paper by Guo and Tang (2006) also gave indirec evidence abou liquidiy and he reurn difference. They sudied he relaion beween liquidiy and reurn of he Chinese firms which issued H shares in Hong Kong as well as A shares in Shanghai. Their sample included 29 firms in he period of July 1993 o December They repored ha he liquidiy measured by urnover raio could explain he reurn difference beween wo cross-lised shares. In shor, he inconsisen findings in he lieraure of he ADRs arbirage possibiliy migh be due o he differen mehods and economeric echniques used in hose papers. However, i is beer o be aware of an obvious rend ha he increasing populariy of ADRs are from emerging markes, and we noe ha he recen sudies upon emerging counries are well differen from he previous works which were exclusively upon developed markes. Which in addiion suggess he arbirage possibiliy of he ADRs may end o exis in he ADRs from emerging markes. 9 Amihud (2002) consruced an illiquidiy measure which is he average daily reurn over rading volume 87

88 3.6 Lieraure review on liquidiy Following he lieraure on he limis of he ADRs arbirage ha illiquidiy effec as he rade-based barriers is one of he possible reasons o hamper arbirage aciviy on he ADRs. In his secion, we will focus on liquidiy wih regard o he concepual erms and dimensions of he liquidiy measuremens Wha is liquidiy Liquidiy is he abiliy o rade large size quickly, a low cos, when he rader wans o rade. I is he mos imporan characerisic of well-funcioning markes. As explained in Harris (2003:394), he liquidiy is he objec of a bilaeral search in which buyers look for sellers and sellers look for buyers and he efficiency of he bilaeral search relaes o he designs of he marke. As saed by Pasor and Sambough (2003) liquidiy is a broad and elusive concep ha generally denoes he abiliy o rade large quaniies quickly, a low cos, and wihou moving he price. Amihud e al. (2005) explained ha he sources of illiquidiy come from a) exogenous ransacion coss such as brokerage fees, order-processing coss, or ransacion axes; b) demand pressure and invenory risk. When he quaniy of demand for a sock does no equal o he quaniy of supply a cerain ime, hen an agen or marke maker may be exposed o he risk of immediaely rading or holding he asse in invenory; c) privae informaion, which may be he privae informaion abou firm s corporae governance, or abou order flow; d) he difficuly of locaing a counerpary ha is willing 88

89 o rade a paricular securiy, or a large quaniy of a given securiy How o measure liquidiy Alhough, he erm liquidiy is no difficul o be undersood, i is quie difficul o measure liquidiy, as Amihud and Mendelson (1991) posied ha liquidiy is no direcly observable and has a number of aspecs all of which canno be capured in a single measure. In pracice, several liquidiy proxies are used and heir impac on sock reurns has been well documened in he exising academic lieraure. The earlier empirical sudies relae asse reurns o differen firm specific liquidiy measures such as bid-ask spread, illiquidiy, urnover, and rading volume. And hese papers view liquidiy as an effecive rading cos o predic he expeced sock reurn. For example, bid-ask spread by Amihud and Mendelson (1986) and Chalmers and Kadlec (1998); ILLIQ as a measure of illiquidiy by Amihud (2002); illiquidiy based on he price response o signed order flow (i.e. using opposie signs for buy and sell orders) by Brennan and Subrahmanyam (1996); urnover raio as he raio beween rading volume and he ousanding shares by Daar e al (1998) and Dey (2005); rading volume by Brennan, Chordia, and Subrahmanyam (1998). The exan liquidiy proxies can be classified as four dimensions of liquidiy: rading cos, rading quaniy or volume, price impac, and rading speed (Liu, 2006). Bid-ask spread (Amihud and Mendelson, 1986) is relaed o rading coss. If a securiy is less liquid and hence is more cosly o rade, hen ha securiy should provide a higher 89

90 gross reurn as compensaion. Turnover raio relaed wih rading quaniy or volume suppors he predicions of Amihud and Mendelson model (Daar, e al., 1998), bu is presence of non-saionary problem and wih random componen are also found (Dey, 2005). ILLIQ, an Illiquidiy measure (Amihud, 2002) is calculaed as he average of daily raio of absolue reurns o volume, which is exacly he concep of illiquidiy, since i quanifies he reurns impac based on a given size of rade Liquidiy risk and liquidiy level There is an increasing aenion of he differen characerisic beween liquidiy risk and liquidiy level. As concluded by Pasor and Sambaugh (2003), he liquidiy measures such as bid-ask spread, illiquidiy measuremens, and urnover raio are all relaed wih he markewide liquidiy level, hese sudies generally find ha less liquid socks have higher average reurns. This risk-facor concern sared from Amihud e al. (1990), who pu forh ha liquidiy change over ime. Amihud e al. (1990) sudied he sock marke crash of Ocober 19, 1987; hey suggesed ha he crash had down-warded invesors belief abou liquidiy which had caused a decline in sock price. Their sudy suggesed a dynamic relaion beween he expeced reurn and liquidiy. Amihud (2002) documened he presence of a ime-series relaion beween heir measures of marke liquidiy and expeced marke reurns. Laer on, Pasor and Sambaugh (2003) emphasized he effecs of he change of liquidiy in erms of ime series and cross-secion. They found ha he covariance beween an asse s reurn and he common liquidiy facor ( liquidiy beas as named in 90

91 heir paper) is priced, and he asse prices should reflec a premium for he sensiiviy of sock reurns o marke-wide liquidiy: Socks wih greaer exposure o marke liquidiy shocks i.e., wih greaer sysemaic liquidiy risk should earn higher reurns. Similarly, Acharya and Pedersen (2005) expanded he model of Pasor and Sambaugh (2003) by involving four facors capuring boh liquidiy level and liquidiy risk. They used Amihud ILLIQ (Amihud, 2002) o measure he marke wide liquidiy level, and employed he liquidiy beas (Pasor and Sambaugh, 2003) o measure liquidiy risk. They also found ha higher (absolue) liquidiy relaed beas lead o higher expeced reurns Trading volume and liquidiy risk Among hese differen liquidiy measuremens, rading volume is special and has no been frequenly documened in he lieraure of liquidiy level. Karpoff (1987) concluded ha in he lieraure heoreical reamen of rading volume arises in hree seings: is relaion o he bid-ask spread, is relaion o price changes, and is relaion o informaion. The inuiion abou he rading aciviy is ha i should be easier o rade in more acive markes, which hen imply a negaive relaion beween rading volume and bid-ask spread. Neverheless, some recen researches invesigaed he relaion beween rading volume and he convenional liquidiy level proxies a marke-wide level, and repored here is lile evidence of he associaion beween hese measures. For example, Jones (2002) found no significan effec of changes in urnover on changes in bid-ask spreads by applying vecor auoregression model o examine he annual daa of he Dow Jones 30 91

92 indusrial socks in a period of Similarly, Evans and Lyons (2002) found no associaion beween rading volume and liquidiy which is ermed as he price impac of rades: rades have more price impac when markes are less liquid, oher hings equal (his is same as bid-ask spread by naure). Ineresingly, Johnson (2007) found a srong posiive conemporaneous relaion beween rading volume and liquidiy risk (measured as he variance of liquidiy, same as he definiion in Amihud e al. (1990), Pasor and Sambaugh (2003)). He considered a coninuous-ime economy populaed by N agens wih consan absolue risk aversion (CARA) preferences, where high volume occurs no when here are large changes o he overall sae of he economy, bu when he mean change in individuals relaive o he average is high. In his model, volume capures somehing closer o he physical concep of flux: he oal (gross) flow ino and ou of he populaion. This, in urn, capures he degree o which he individuals wihin he populaion have been rearranged. He concluded ha he scale of liquidiy innovaions liquidiy risk should be posiively relaed o volume, because inuiively, large changes in liquidiy canno occur wihou a lo of populaion flux, and a small amoun of flux mus imply a small change in liquidiy. 3.7 Conclusion We review hree main issues in he lieraure of he ADRs. Firs, he moivaions o cross lis shares is from he poin of he firms, since firms inenion o cross-lising is obvious, he research abou his issue are relaively few han abou he oher wo issues. Second, he price discovery process is from he poin of view of marke. Mos of he cross-lised socks are from emerging markes which end o be segmened. Among a number of 92

93 segmenaion facors, he papers reviewed poin o asynchronous rading hours is he mos imporan facor. Price discovery process ends o ake place in he US marke when he underlying marke is wih larger over-lapping rading hours wih he US. Third, he ADRs arbirage is from he poin of view of invesors. The persisen mispricing arises from gambling aciviies beween he informed raders (arbirageurs) and he noise raders. Finally, we also review he papers abou liquidiy effec. In paricular, we focus on he difference of several convenional liquidiy measuremens, and pay aenion o he difference of liquidiy level and liquidiy risk. From he lieraure, we also noe ha he price discovery of he Chinese ADRs has been sudied by Xu and Fung (2002). So our objecive will be mainly on he issue of he Chinese ADRs arbirage. 93

94 Chaper 4 Reurns Spread and Liquidiy of he Chinese ADRs 4.1 Inroducion We are going o perform he main empirical examinaions on he Chinese ADRs arbirage in chaper 4. From he lieraure of he ADRs arbirage surveyed in chaper 3, we concluded ha he invesigaion on he Chinese ADRs arbirage could be processed in wo seps. The firs examinaion is o find ou wheher he Law of One Price (he Law hereafer) exiss beween he Chinese ADRs and heir underlying H shares. The second is o examine he facors which impede arbirageurs o close price differenials beween wo securiies. Wih regard o he firs sep, according o he Law, if markes are efficien, he ADRs and heir underlying shares are supposed o be raded a he same price and very lile arbirage profi would exis beween hem. However, if he Chinese ADRs are ruly raded a same price as heir underlying H shares adjused for he exchange rae, hen i would be difficul o explain some remarkable marke phenomena ha we have quie ofen observed; ha hedge funds are among he op 10 shareholders of hese Chinese ADRs. Given he naure of he hedge funds, his pracical evidence clearly suggess he exisence of deviaion beween he prices of hese wo idenical securiies and implied a possible arbirage profi. On closer examinaion of he papers on he ADRs arbirage possibiliy, we noiced he findings of hese papers are inconsisen, which we believe is due o differen mehodologies applied. Some earlier papers employ basic saisical ess such as -es 94

95 and Wilcoxon signed-rank es which are only sensiive o locaion, as well as correlaion ess o compare he reurns of he ADRs and he underlying shares. These papers repor no significan differences exis beween home and hos securiies prices, and hus conclude ha very few profiable arbirage opporuniies persis beween any of he home markes and he US marke (see Kao e al (1991), Miller and Morey (1996), and Karolyi and Sulz (1996)). On he oher hand, Wahab e al (1992) used porfolio approach and found small bu significan differences beween prices of some ADRs and heir underlying securiies. Furhermore, Rabinovich e al (2003) employed non-parameric mehods o compare reurn disribuion of he ADRs and heir underlying shares; hey found ha even when he means and medians are no differen here may sill be differences in higher momens for securiies reurn disribuions. In his chaper, we will use boh sandard locaion ess as Kao e al (1991), Miller and Morey (1996), and Karolyi and Sulz (1996), as well as non-parameric ess o compare reurn disribuion as Rabinovich e al (2003). In he lieraure on financial markes, he disribuions of reurns of he cross-lised securiies have long been he subjec of researches for he Law. In paricular, he disribuions of he reurns of ADRs and heir underlying shares are compared o es he implicaions of he Law in recen published papers. Due o he fac ha here is ample empirical evidence ha he disribuion of shor-erm securiy reurns, e.g., daily, weekly or monhly, is non-normal (Campbell, Lo and MacKinlay, 1997), reurn disribuion sudies pay aenion o he higher momens especially on skewness and kurosis, insead of on he lower momen such as mean. Skewness is a measure of symmery, or more precisely, he lack of symmery. A normal disribuion is symmeric of he cenre poin. 95

96 Kurosis is a measure of wheher he daa are peaked or fla relaive o a normal disribuion. Daa se wih high kurosis end o have a disinc peak near he mean, decline raher rapidly, and have heavy ails. Daa se wih low kurosis end o have a fla op near he mean raher han a sharp peak. The deviaion from normal disribuion in he higher momens leads o newly developed financial analysis mehods and porfolio sudies, for example, he Copula weighed porfolio which is based on he ail dependence beween markes and risk facors. This approach applies widely in he researches of hedge funds sraegy and he comovemen beween marke indices. Alhough he porfolio approach moivaes us o carry ou he reurn disribuions sudy, i will no be discussed in his hesis because of he limiaion of ime and we leave i for furher exension in fuure. Wih respec o he second sep, we will follow he approach of Gagnon and Karolyi (2004). This paper no only repored evidence of exisence of significan mispricing in he ADRs, bu also specified he various cross-secional aribues a he counry-, indusry- and firm-level. They furher grouped hese aribues ino hree major caegories of barriers or fricions: marke-based, informaion-based, and rading-based. Marke-based barriers can include direc and indirec invesmen barriers faced by he foreigners, which address he quesion abou he segmened marke hypohesis. Informaion-based barriers are he asymmeric informaion abou noise rader risk across he hos and home marke as well as he asymmeric informaion beween corporae insiders and oher shareholders, which hamper professional arbirageurs o be agains noise rader, so he mispricing would be persisen for an exended period. Trading-based barriers are he illiquidiy in he home marke for he underlying shares or in he US 96

97 marke for he ADRs, since he ADRs are usually no frequenly raded, arbirage aciviy may be impeded for he fear of illiquidiy. In paricular, we es he informaion-based and he rade-based barriers on he limi of he ADRs arbirage. These wo barriers are examined as comovemen effec and illiquidiy effec in he paper of Gagnon and Karolyi (2004). According o Froo and Dabora (1999), De Jong e al. (2004), and Gagnon and Karolyi (2004), he comovemen effec arises due o he noise rader risks. Noise raders end o move wih he local marke, so he noise rader risks would have differen exen and are usually asynchronous in he hos and home markes. The professional arbirageurs who are usually wih limied horizons would no be able o remove he mispricing for fear of he noise rader risk. As a resul, he mispricing can be persisen over long period. Apar from he comovemen effec, we furher es he illiquidiy effec. Gagnon and Karolyi (2004) provided evidence ha he greaer he illiquidiy in one or he oher or boh markes, he greaer he ne marke risk exposures revealed for he reurn differences beween he ADRs and he underlying shares. In addiion, as analyzed in chaper 2, we inroduce he marke microsrucure and rading mechanisms of he hree China-relaed exchanges, and compare he rading mechanisms and he rading coss of hese hree exchanges wih ha of he NYSE and NASDAQ. We find ha he size of he Shanghai and Shenzhen sock exchange is exremely small compare o ha of he Hong Kong sock exchange as well as o ha of he NYSE and NASDAQ. A large sock exchange ends o provide bigger widh and deph, and herefore greaer liquidiy. Second, we show ha due o he employmen of differen rading mechanisms, a noable difference among hese sock exchanges is wheher he marke makers exis. The NYSE and NASDAQ are dealer 97

98 marke and all ransacion mus be processed by he marke makers, he Shanghai and Shenzhen sock exchanges are aucion markes where no marke makers exis; all ransacion are cleared hrough elecronic rading sysem, and he Hong Kong sock exchange hough has a small number of marke makers, i is designed as an aucion marke and all ransacions are carried ou hrough elecronic rading sysem, he marke makers in he Hong Kong sock exchange will supply liquidiy only on very paricular siuaions, bu no be involved in he daily frequen exchanges. Marke makers no only play a criical role in providing liquidiy, some of he marke makers or dealers also ake par in block rades. Block rades accoun for abou 50% of he daily rading value in he US equiy markes, however, here are nearly no block rade in Hong Kong or Shanghai sock exchanges. In conclusion, we suspec ha liquidiy is also one of he imporan aribues of he ADRs mispricing. Finally, we have inroduced he marke liberalizaion of China s sock marke in chaper 2, and we have explained ha he disincive characerisic of he Chinese ADRs is due o he fac ha hey connec hree markes, he US, Hong Kong, and China s sock markes. We view he imporan reforms of he China s sock marke as he innovaion, and ry o find if he marke innovaions would have any impac on he Chinese ADRs price. So we process o es for he effecs of srucural change on he comovemen effec. The chaper proceeds as follows: secion 4.2 conains an inroducion he Chinese ADRs; secion 4.3 explains he hypohesis and mehodology; secion 4.4 provides a descripion of he daa; secion 4.5 is he empirical resuls of ess; secion 4.6 concludes. 98

99 4.2 Overview of he Chinese American Deposiory Receips (ADRs) By he end of 2006, 59 Chinese firms have accessed he US markes by issuing ADRs. Among hose, 16 are lised on he NYSE, 17 on he NASDAQ, and 26 on he OTC marke. China s firs overseas IPO, Brilliance China Auomoive (CBA) was lised on he New York Sock Exchange (NYSE) on Ocober 1992 and raised US$ 80 million. The 59 Chinese ADRs have some ineresing feaures; he 16 firms lised on he NYSE are all SOEs wih monopoly power in he domesic marke; hey operae in some criical indusries, such as elecric power, peroleum, airline, and elecom. These companies firs issue H shares and hen make he H shares serve as backing for heir ADR programs, where he receips are poenially converible ino he underlying H shares, (excep for Huaneng Power Inel (HNP) and Brilliance China Auomoive (CBA), which issue IPO on he NYSE before issue H shares in Hong Kong, and hen combine ADRs wih heir H shares insead of exising shares in he US). The 17 firms lised on he NASDAQ are all young privaely owned IT companies, hese firms do no issue H shares in Hong Kong, and hey firs issue IPOs on he NASDAQ, hen conver par of he IPOs o ADRs. The 26 firms on he OTC marke have differen characerisic, hey are also SOEs bu do no enjoy a monopoly posiion. Finally, in he OTC marke, 11 firms have H shares as underlying shares, 6 firms have B-shares as underlying shares, and 9 firms have underlying shares issued in he US. One ineresing hing deserving our aenion is o look a how he Chinese NASDAQ-lised firms enlis abroad. Firs, he iming of Chinese IT firms o lis on he NASDAQ is relaed wih he NASDAQ surge, he firs surge is around 1999, however 99

100 he Chinese IT indusry jus sared since hen, compuer owners and inerne users were sill very few in 1999, he second surge sared from 2003 in NASDAQ, and provided good opporuniies for he well-developed Chinese IT firms. Second, he manner of hese Chinese IT firms lising abroad is enirely differen from hose lised on he NYSE. a) All of hese firms in NASDAQ are privae, so hey don have suppor from he governmen. b) These firms have smaller shareholder base and marke capializaion, which make mos of hem ineligible o lis in Hong Kong. c) Mos of hese firms merge wih a shell company in he US, and regiser in he free-ax heavens such as Bermuda, Cayman Islands before heir lising on NASDAQ. This way of lising coninued unil 2005 when China s governmen issued regulaions o ban Chinese privae firms o lis abroad in his way and as a resul of which, all he Chinese NASDAQ lised firms have close lising daes beween 2003 and Research Mehodology and Hypohesis Developmen To es he law of one price The objecive of his chaper is o examine he arbirage possibiliy beween he 15 NYSE-lised Chinese ADRs and heir underlying H shares, and if here are any price deviaions, we will addiionally measure hese price differenials aking ino consideraion he impac of he marke facors and he liquidiy risk. As he lieraure survey on he ADRs arbirage in chaper 3 has indicaed ha he locaion ess such as -es and Wilcoxon signed-rank es end o uncover an equaliy relaion beween he price pariy and sugges ha he law of one price exiss beween wo 100

101 securiies, while he Kolmogorov-Smirnov es, which is well-known for is sensiive o boh he locaion and shape of a disribuion, end o reveal he difference in he disribuion, for insance, he difference in skewness and kurosis. And we have discussed he imporance o be aware of he disribuion difference in he inroducion of his chaper. Therefore, we will use boh he approaches of Rabinovich e al. (2003) and ha of Kao e al. (1990) o es he law of one price. We will apply -es, Wilcoxon signed-rank es, Kolmogorov-Smirnov es, and he parameric join es of simulaneous means and variance equaliy 10. Our null hypohesis is; here is no difference in he reurn disribuion of wo securiies, and he alernaive hypohesis is of he opposie To es he comovemen effec on mispricing Secondly, as reviewed in chaper 3, he lieraure of segmened markes suggess several possible inernaional barriers ha may influence how securiies are priced in heir respecive marke, for example, resricions on foreign ownership, ax, illiquidiy, non-synchroniciy, ec. Wih regard o he Chinese ADRs, he underlying marke is Hong Kong which is a free marke as he US marke wihou resricions on foreign invesors; so we expec invesors in he wo markes could freely buy or sell shares in boh he domesic and cross-border markes. On he oher hand, Hong Kong has pegged is exchange rae wih he US dollar since 1983, so he inernaional raders would expose o zero risk in exchange rae. The criical facor in he Chinese ADRs rading is he non-synchronous rading hours beween he US and Hong Kong marke. The 12-hour s 10 The original es mehod can be found in Bradly and Blackwood (1989). A simulaneous es for means and variances. Am. Saisician 43,

102 difference beween he wo markes induces non-overlapping rading in wo markes. In chaper 3, he comovemen effec suggess securiies end o sysemaically move wih he local marke index, and Gagnon and Karolyi (2004) showed he ADRs have a higher sysemaic comovemen wih he US marke index han he comovemen wih he home marke. Therefore, we develop our esing in wo seps: firs, we follow Kao e al. (1991) who applied correlaion es on he reurns of he ADRs and heir underlying shares, and repored significan correlaion beween wo securiies wih regard o boh conemporaneous and lead-lag relaion; and hey concluded ha he US and he home marke are weak-form efficien and inegraed fully, here exiss no arbirage possibiliy. We will employ Spearman correlaion es and Pearson correlaion es o examine he reurns of he Chinese ADRs and he underlying H shares. Second, we follow De Jong e al. (2003) and Gagnon and Karolyi (2004) o examine he comovemen effec of wo securiies. The implicaion of he comovemen effec is ha he ADRs (he underlying H shares) end o move more closely wih he US (Hong Kong) marke index han Hong Kong (he US) marke index. Because if he ADRs (he H shares) move wih local and off-shore marke equally, hen he noise rader in he US (Hong Kong) marke would no creae differen risk of he price of he securiies o deer he arbirageurs. Furher, by reason of he asynchronous rading hours, i is difficul o ell wheher mispricing exiss if we exclusively focus on conemporaneous relaion. Likewise, arbirage may no remove mispricing wihin one day because of he ime needed o complee he necessary rades. Especially, he US marke opens 12 hours laer han Hong Kong, so he Hong Kong marke index a day may be refleced by he US 102

103 marke index a day +1, so we consider he comovemen effec in he longer horizon; we ake he firs sage ime series regression model as De Jong e al. (2003) and Gagnon and Karolyi (2004) and give our model as bellow: ADR r - r HK = α US 0 US US HK HK + β i R + i + β i R + i + ε (1) i= 2 0 i= 2 Where r i refers o he reurns for securiy i (H share or ADR) on day, ( r ADR - r HK ) is he reurn spread beween wo securiies a day. We calculae he coninuously-compounded reurn as (ln (P /P -1 )). US R is he reurn on he US (hos) marke on day, HK R is he reurn on Hong Kong (underlying) marke on day. Furher, some of hose Chinese ADRs are also subsequenly lised on he Shanghai Sock Exchange (SHSE). The shares lised on he Sock Exchange of Hong Kong (SEHK) are H shares, which allow foreign ownership and are raded in Hong Kong currency while he shares lised on SHSE are A shares available only o he Chinese ciizens and raded in Chinese currency. And in chaper 2, we have discussed ha here is sric resricion on he ownership of A shares as well as he limiaion for he Chinese ciizens o own foreign currency, given ha H shares mus be raded a Hong Kong currency, ha sops any arbirage possibiliy beween H shares and A shares, even as we have inroduced in chaper 2 ha a huge price discoun exiss beween A shares and H shares. For he ADRs have A shares in Shanghai sock exchange, we also include Shanghai marke reurns as an explanaory variable in spie of he evidence ha he Chinese marke and he global marke in general and he US marke in paricular are no correlaed. Ye, Shanghai marke may have an indirec impac on he Chinese ADR 103

104 reurns hrough Hong Kong marke. This is because some of our empirical evidence suggess an inverse correlaion (negaively relaed) beween he marke reurns of Hong Kong and Shanghai. While he correlaion is expeced, he inverse correlaion is surprising given ha he markes in Hong Kong and Mainland China are inegraed due o heir common culure, inerdependence, and cooperaion in business. They also have 7 overlapping opening hours of sock exchanges during which poliical and economic news in China are likely o impac H shares performance in Hong Kong, which may hen ransmi from he H shares o he ADRs in US due o he inegraion beween US and Hong Kong markes. A possible explanaion for he inverse correlaion is ha Hong Kong and Shanghai markes compee for funds and hus one marke can gain only a he cos of he oher. Our null hypohesis is ha if wo markes are weak form efficien and fully inegraed, hen he differenial of he reurns of wo securiies is zero. So he coefficien of he US and Hong Kong marke indices should be zero. Therefore, he alernaive hypohesis is ha if he wo markes are segmened, hen marke shocks can explain movemens in he reurn differenial, he reurn differenial is posiively affeced by a posiive shock in he US marke index and negaively affeced by a posiive shock in he Hong Kong marke index To es he liquidiy effec on mispricing As discussed in chaper 3, along wih Karolyi (1998), De Jong e al. (2003), Gagnon and Karolyi (2004), ec., several heoreical and empirical sudies have examined he 104

105 mispricing of he paired raded socks, and have carried ou invesigaions on he issues relaed wih marke imperfecions, limis o arbirage, noise rader risk, or a combinaion of hese argumens. Alhough quie a few papers have argued ha he illiquidiy across markes could be one of he aribues o he mispricing, i is no unil recenly did researchers begin a rigorous sudy of wheher a difference in liquidiy (DIL) beween markes explains par of his phenomenon. The srong evidence of he liquidiy effec on he ADRs mispricing are given by Chan e al. (2008), who argued when similar securiies are raded a differen prices a differen markes, he liquidiy or illiquidiy in hese markes also differ in he direcion, for example, a rise of he liquidiy (illiquidiy) in he US marke will lead o a decrease (increase) on he ADRs price differenials, likewise, a rise of he liquidiy (illiquidiy) in he underlying marke will lead o a increase (decrease) on he ADRs price differenials. Their resuls clearly suppor he illiquidiy effec as concluded in Gagnon and Karolyi (2004). As we have poined ou in chaper 3 ha i is crucial o selec proper liquidiy measures from a full range of liquidiy proxy candidaes. The simples and he mos radiional illiquidiy measure is he bid-ask spread calculaed by Amihud and Mendelson (1986), his proxy has been widely used in empirical researches. Unforunaely, i is difficul o apply he bid-ask spread in our hesis due o consrains on daa availabiliy. Bid-ask spread need o use inra-day daa, alhough inra-day daa on ransacions and quoes are available for he ADR marke in he US, i is no available for he H shares. As a resul, we have o use alernaive liquidiy measures ha use only daily reurn and volume daa as inpus. Same as Chan e al. (2008), we decide o use ILLIQ (Amihud, 2002) as he 105

106 illiquidiy measure. ILLIQ is defined as he average of daily raio of volume o absolue reurn, he meri of his measure is ha i measures he daily price impac of he order flow, which is exacly he concep of illiquidiy, since i quanifies he price/reurn response o a given size of rade (Chan e al., 2008). Therefore, we calculae daily ILLIQ as: ILLIQ = r vol Where ILLIQ is he daily illiquidiy proxy, r is he absolue value of reurn a day, vol is he rading volume a day. Chan e al. (2008) also employed urnover raio as alernaive liquidiy measure. Turnover raio is calculaed by he raded volume divided by he oal ousanding shares, i measures how acively he sock is raded. However, given he specific characerisic abou he Chinese ADRs ha he Chinese ADRs are backed by he H shares, hese ADRs firms issued H shares in Hong Kong and hen sold small par of H shares as he ADRs in he US marke, hen he urnover raio, he relaive raio beween raded shares and ousanding shares, will no be able o ell if he ADRs is raded more acively han he H shares, because mos par of he floaing shares will remain in he Hong Kong marke. As a resul, we decide o choose rading volume as one of our liquidiy measures; we view rading volume as a proxy capuring liquidiy risk. As we have discussed in chaper 3, in he lieraure of liquidiy, i is imporan o be aware of he difference of wo liquidiy dimensions: he liquidiy level and he liquidiy risk. The level of liquidiy is he predicable par of he radabiliy of he securiy wihou suffering he adverse consequences of marke impac. Liquidiy risk, on he oher 106

107 hand, arises from he unpredicable changes in liquidiy over ime. Johnson (2007) demonsraed ha he scale of liquidiy innovaions (liquidiy risk) is posiively relaed o volume, because inuiively, large changes in liquidiy canno occur wihou high rading volume, and a small amoun of rading volume mus imply a small change in liquidiy. Therefore, we use rading volume as alernaive measure of liquidiy risk, and we give our model as below: ADR HK ADR ADR HK HK r r = α + β1 ILLIQ + β2 ILLIQ + ε (2) ADR HK ADR ADR HK HK r r = α + β3 liq + β4 liq + ε (3) Where ADR r and r HK are he reurn a day, ILLIQ is he proxy measuring illiquidiy for ADRs and H shares a day, liq is calculaed by he logarihms of rading volume a day for ADRs and H shares. Equaions (2) and (3) aim o capure wheher he exposure o he illiquidiy and liquidiy risk would impac on he reurn differenials. Our null hypohesis is mispricing beween he ADR and H share is zero, herefore, he bea of each he liquidiy proxies equal o zero. The alernaive hypohesis is ADR β 1 is posiive while HK β 2 is negaive, because he posiive illiquidiy-reurn relaion. And β ADR 3 is posiive and ADR β 4 is negaive, because high liquidiy risk should lead o high reurn. 4.4 Daa and descripive saisics Daa Our sample of he Chinese ADRs is drawn from he Bank of New York s Complee DR Direcory, which is available on he web ( This direcory provides he 107

108 issuer name, symbol, CUSIP number, lising marke (Rule 144A, AMEX, NASDAQ, or NYSE), ADR bundling raio, home counry, indusry, region, and he name of he sponsoring bank if he issue is sponsored. The informaion abou he lising hisory of he H shares is drawn from he websie of Hong Kong sock exchange. Our sample includes 15 pairs of NYSE-lised ADRs and H shares, he sample period varies depends on individual socks, he longes is of SHI (SINOPEC Shanghai Perochemical Company LTD) which begins on Ocober 1993, he shores period is of CEO (CNOOC China Naional Offshore Oil Co.) which begins on April 2004, he sample period for all ADRs and H shares end on Ocober We obain daily close price afer adjused wih dividends, rading volume and marke indices from DaaSream Advance 4.0. As of Ocober 2006, here are 33 Chinese ADRs (ADR level III) lised on he US sock exchanges; anoher 26 (ADR level I) are raded on he OTC. Among he exchange lised ADRs, 16 are lised on he NYSE and 17 on he NASDAQ. For he purpose of his sudy, we are specifically focusing on he NYSE-lised ADRs since we aim o es he arbirage possibiliy. We furher exclude one NYSE-lised ADR, namely STP, due o his ADR was lised on Dec of 2005 and is ime period is less han one year up o our sample ending dae. We exclude he ADRs lised in NASDAQ, because hese ADRs do no have underlying shares in he sock exchange oher han NASDAQ, we also exclude he ADRs lised in OTC, because hese ADRs canno provide he examinaion on he comovemen effec due o he inabiliy of a proper marke index. We hen group 15 ADRs ino wo porfolios: Porfolio I consiss of 9 socks lised on he NYSE wih underlying shares in Hong Kong sock exchange; Porfolio II consiss of 6 socks lised on he NYSE wih H shares in Hong Kong sock exchange, and A shares in Shanghai sock exchange. 108

109 Table 4.1 overview of he Chinese ADRs lised on he NYSE and NASDAQ as of Ocober 2006 NYSE lised Chinese ADRs Company name ADR Symbol Lising Dae HK Underlying Shares HK Lising Dae SH Home Shares SH Lising Dae Indusry Conversion Raio Average price ($) Average rading volume ($) CHINA EASTERN AIRLINES CEA 01/ / /97 Travel & CORPORATION LIMITED Leisure CHINA PETROLEUM & SNP 10/ / /01 Oil& Gas CHEMICAL CORPORATION Producers CHINA SOUTHERN AIRLINES ZNH 04/ / /03 Travel & CO., LTD. Leisure HUANENG POWER HNP 10/ / /01 Elecriciy INTERNATIONAL, INC. SINOPEC SHANGHAI SHI 07/ / /93 Chemicals PETROCHEMICAL COMPANY LIMITED YANZHOU COAL MINING YZC 04/ / /98 Mining COMPANY LIMITED ALUMINUM CORPORATION ACH 12/ /01 N/A N/A Indusrial OF CHINA LIMITED Meals BRILLIANCE CHINA CBA 10/ /99 N/A N/A Cars & Pars AUTOMOTIVE HOLDINGS LIMITED CHINA LIFE INSURANCE LFC 12/ /03 N/A N/A Life COMPANY LIMITED Insurance CHINA MOBILE (HONG CHL 10/ /97 N/A N/A Mobile KONG) LIMITED Telecom CHINA TELECOM CHA 12/ /02 N/A N/A Fixed Line CORPORATION LIMITED Telecom CHINA UNICOM LIMITED CHU 06/ /00 N/A N/A Mobile Telecom. CNOOC - CHINA NATIONAL CEO 02/ /04 N/A N/A Oil& Gas OFFSHORE OIL CORP Producers GUANGEN RAILWAY GSH 05/ /96 N/A N/A Travel & COMPANY LIMITED Leisure PETROCHINA COMPANY PTR 03/ /00 N/A N/A Oil& Gas LIMITED Producers

110 NASDAQ lised Chinese ADRs 51JOB, INC. JOBS 10/04 N/A N/A N/A N/A IT BAIDU.COM, INC. BIDU 08/05 N/A N/A N/A N/A IT CHINA FINANCE ONLINE CO., JRJC 10/04 N/A N/A N/A N/A IT LTD. CHINA MEDICAL CMED 08/05 N/A N/A N/A N/A IT TECHNOLOGIES CHINA TECHFAITH WIRELESS CNTF 05/05 N/A N/A N/A N/A IT COMMUNICATION LIMITED CTRIP.COM INTERNATIONAL, CTRP 12/03 N/A N/A N/A N/A IT LTD. ELONG, INC. LONG 11/04 N/A N/A N/A N/A IT FOCUS MEDIA HOLDING FMCN 07/05 N/A N/A N/A N/A IT LIMITED HURRAY! HOLDING HRAY 02/05 N/A N/A N/A N/A IT COMPANY LTD. LINKTONE LTD. LTON 03/04 N/A N/A N/A N/A IT NETEASE.COM, INC. NTES 06/00 N/A N/A N/A N/A IT NINETOWNS DIGITAL NINE 12/04 N/A N/A N/A N/A IT WORLD TRADE HOLDINGS LIMITED SHANDA INTERACTIVE SNDA 05/04 N/A N/A N/A N/A IT ENTERTAINMENT LIMITED THE9 LIMITED NCTY 12/04 N/A N/A N/A N/A IT STP, ACTS, VIMC are excluded from our empirical sudy, because heir effecive dae is afer Oc 2005, he ime period is no enough for one year. 2. The conversion raio indicaes he number of underlying shares in Hong Kong ha corresponds o one ADR share in New York, and his number is of Ocober In order o compare reurns from differen markes, he sample period for each firm sars on he lising dae of ADR or H shares of he company, whichever is laer. 110

111 Table 4.1 conains an overview of he Chinese ADRs lised on NYSE and NASDAQ, he corresponding underlying securiies, if available on Hong Kong (SEHK) and addiional lising on Shanghai (SHSE) sock exchanges along wih he respecive lising monh and year in each exchange. We observe ha he lising, monh and year and paricularly he years in which he ADRs were issued reveal some sraegic decisions on he par of he issuing Hong Kong firms o enlis heir ADRs The Chinese ADRs lising hisory and lising paern We summarize he NYSE-lised Chinese ADRs lising hisory in he following Graph 4.1. Graph 4.1: Yearly ADR lising by Hong Kong firms during he sample period. # of ADR Firs, as Graph 4.1 indicaes, he Chinese ADRs lising during our sample period do no show any rend or any oher discernible regulariy; srikingly hough, more han 50% (8/15) ADRs were lised beween 2000 and A reasonable hypohesis for his srucural shif in 2000 may be he marke collapse in US, paricularly he IPO marke,

112 which led some Hong Kong firms 11 o offer heir securiies o he US invesors as alernaive invesmen opions. Second, as we have menioned in he inroducion of his chaper, we aim o invesigae he impacs from a se of reforms happened in China s domesic sock marke around Since par of hese NYSE-lised ADRs addiionally lised A shares in Shanghai sock exchange afer hey sequenially lised in he Hong Kong sock exchange and he NYSE. Given he close relaion beween Hong Kong and China, we expec ha China s sock marke would have some indirec impacs on hese ADRs hrough her connecion wih Hong Kong. Therefore, we will laer use 2000 and 2003 as our wo srucural shif poins for regression analysis. We also noice ha some ineresing lising behavior exis in hese ADRs. Firs, almos all lisings on he Hong Kong marke and on he NYSE were done almos simulaneously (wihin a monh) for all he ADRs, and predae lising on he Shanghai marke for he ADRs wih A shares lised in Shanghai 12. The quesion abou hese firms moivaion o lis A shares in Shanghai is worh our concern. While he moivaion behind he Hong Kong firms o cross lis in he US o arac more capial is obvious, he implicaions for hese firms o cross-lis in Shanghai sock marke is no clear. According o our research on he rading coss and marke condiions in chaper 2, we know he Shanghai sock exchange has far less liquidiy, deph, and widh han ha of Hong Kong. Then i seems o conradic he convenional wisdom ha firms cross-lising is o achieve 11 For he purpose of his sudy, we name hese Chinese firms as Hong Kong firms o differ hem from he Chinese firms wihou issuing H shares, because hey issue IPO on he SEHK, and behave more like Hong Kong firms raher han Chinese mainland firms, he deails are discussed in chaper HNP is an excepion ha issued H shares in 1998, A shares in 2001, and ADR in This order of lising for all securiies excep HNP i.e., lising as ADRs prior o or simulaneously on Hong Kong exchange prevens us from invesigaing he announcemen effec around cross lising. 112

113 lower cos of capial and greaer liquidiy. Furher i raises quesions abou hose Chinese ADRs which do no lis A shares in Shanghai, and hose NASDAQ-lised ADRs which do no lis in any of heir home counry exchanges. The answer may lie in he ownership srucure of firms since he firms wih addiional cross lising in Shanghai are SOEs wih srong poliical ies wih he Chinese governmen. In able 4.1 above, we also lis he corresponding indusries which hese firms belong o. We find ha all NYSE-lised ADRs belong o four indusries - uiliies, communicaion, ravel and leisure, and heavy engineering and indusrial producs. The indusry disribuion for he NASDAQ ADRs is differen; hey are all young IT firms. Compared o he large indusrial base of China, he ADRs from China seem o be from a very selecive indusry core. Table 4.2 gives he overall disribuion of all Chinese lised firms in domesic sock marke as of Table 4.2 Overview of he Chinese lised firms indusry disribuion (2006) Indusry No. Indusry No. Agriculure, Foresry, Fishing and Huning 38 Mining 25 Food, Beverage 61 Texile, Appeal, Leaher 68 Wood Produc 4 Paper, prining 30 Peroleum, Chemical Produc, Plasics, Rubber 153 Elecrical Equipmen 51 Meal, Non-meallic Mineral produc 130 Machinery, Equipmen, Meer 227 Medicine, Biologic produc 91 Oher manufacuring 20 Elecriciy, Gas, Waer supply 62 Consrucion 31 Transpor, Sorage 63 Informaion, Technology 90 Wholesale and Reail Trade 92 Finance, Insurance 12 Real Esae 55 Social Services 42 Transmission, Culure 10 Conglomerae 78 Toal lised firms: 1433 Source: 2006 Yearbook from hp:// Descripive saisics on ADRs and H shares reurns We compue coninuously compounded reurns on he ADR lisings in US exchanges and 113

114 heir corresponding underlying socks lised in he Hong Kong Sock Exchange (and i i i Shanghai Sock Exchange as applicable) as r = ln( P / P 1) where i P denoes adjused closing price of securiy i on day. The sample period for each pair of ADR and he underlying securiy begins from he laes lising daes of he ADR or HK securiy 13 and ends in Ocober 2006 and he acual number of observaions for each securiy used in our analysis is repored in Table 4.3. Table 4.3: Descripive saisics on daily reurns ADR r and HK r Symbol Obs. Mean Sd. Dev Min Max Skewness Kurosis Porfolio I ACH [2600.hk] % (0.107%) 2.99% (3.14%) (-0.149) (0.144) (0.098) (4.358) CBA [1114.hk] % (0.010%) 3.08% (3.63%) (-0.219) (0.221) (0.285) (7.743) LFC [2628.hk] % (0.178%) 2.26% (2.09%) (-0.081) (0.099) (0.199) (5.722) CHL [0941.hk] % (0.078%) 2.93% (2.76%) (-0.165) (0.156) (0.253) (7.076) CHA [0728.hk] % (0.074%) 1.93% (1.89%) (-0.083) (0.075) (-0.017) (4.273) CEO [0883.hk] % (0.113%) 1.89% (1.94%) (-0.075) (-0.077) (0.090) (0.059) (4.351) GSH [0525.hk] % (0.010%) 2.88% (3.09%) (-0.203) (0.185) (0.002) (7.680) PTR [0857.hk] % (0.136%) 2.03% (2.03%) (-0.107) (0.099) (0.155) (5.340) CHU [0762.hk] % (-0.042%) 2.82% (2.67%) (-0.131) (0.143) (0.078) (5.338) Porfolio II CEA [0670.hk] SNP [0386.hk] ZNH [1055.hk] HNP [0902.hk] SHI [0338.hk] YZC [1171.hk] % (-0.006%) 0.072% (0.095%) 0.004% (0.007%) 0.051% (0.054%) 0.021% (0.016%) 0.037% (0.049%) 3.32% (3.94%) 2.45% (2.37%) 3.67% (3.85%) 3.29% (3.14%) 3.38% (3.80%) 3.76% (3.81%) (-0.375) (-0.090) (-0.327) (-0.167) (-0.239) (-0.487) (0.267) (0.104) (0.296) (0.207) (0.304) (0.268) (0.225) (-0.063) (0.259) (0.383) (0.328) (-0.848) (10.196) (4.248) (9.947) (6.775) (8.144) (18.087) Table 4.3 provides descripive saisics on reurns on ADR and he underlying 13 Since mos Chinese ADRs have differen lising dae wih H shares, for our paricular research purpose, we choose sample period saring from he dae when ADR or H shares lised laer. 114

115 securiies lised a SEHK. In porfolio I, he number of observaions vary from 645 (CEO) o 2827 (CHL), while in Porfolio II, he minimum and maximum observaions are 1504 (SNP) and 3282 (SHI) respecively. The annualized reurns on he ADRs (Hong Kong shares) range from % (-37.56%) o 37.30% (30.42%) wih a mean of 5.33% (5.91%), however, afer spliing he ADRs and he underlying H shares ino Porfolios I and II he means of ADR (H shares) break down as follows: 7.21% (7.28%) for Porfolio I and 2.53% (3.85%) for Porfolio II. Thus he average reurns for porfolio I for he underlying H shares and ADRs are higher han hose of Porfolio II. Furher he H shares in Porfolio II seem o be ouperforming heir ADR counerpars. The saisics show ha hree socks, CHA, SNP, and YZC, eiher of he ADRs or of he H shares, are negaively skewed, alhough he skewness saisics are no large. The negaive skewness implies ha he reurn disribuions of he shares have a heavier ail of large values and hence a higher probabiliy of earning negaive reurns. The kurosis values are very much larger han hree, his resul shows clearly ha for mos series, he disribuion of reurn have fa ails compared wih he normal disribuion. I implies ha much of he non-normaliy is due o lepokurosis. Nex, we compue reurn spread as he difference beween he reurns of each ADR and ha of is corresponding underlying H shares respecively. We selec he reurn daa by maching wo daa se a same dae, since he US and Hong Kong marke have differen holidays, so we exclude he reurn daa which canno be mached. Our measure of reurn spread is same as Gagnon and Karolyi (2004) and Rabinovich e al (2003). I denoes arbirage profi and is equivalen o ADR premium, he percenage difference in prices beween ADR and is underlying securiy. 115

116 Table 4.4: Saisical disribuion of reurn spread ( r ADR - r HK ) Symbol Obs. Mean Sd. Dev Min Max Skewness Kurosis Porfolio I ACH % 0.9% CBA % 0.826% LFC % 1.56% CHL % 2.37% CHA % 1.45% CEO % 1.59% GSH % 3.09% PTR % 1.61% CHU % 2.28% Porfolio II CEA % 1.56% SNP % 0.81% ZNH % 3.09% HNP % SHI % 1.54% YZC % 3.25% Table 4.4 conains descripive saisics on reurn spreads ( r ADR - r HK ) for 15 pairs of he Chinese ADRs separaed ino Porfolios I and II. The mean reurn spread is small, ranges from -1.5 basis poin o 2.5 basis poin 14, from he mean value of reurn spread, we can no predic ha mispricing exiss and he arbirage profi will by some chance cach he aenion of arbirageurs. However, we noice he skewness is negaive for four ou of nine ADRs in porfolio I and negaive for all ADRs in porfolio II. And once again, we find a large kurosis in all ADRs, especially very much higher for he ADRs in porfolio II han hose in porfolio I. A negaive skew indicaes he disribuion is lef-ailed, he lef ail is longer han he righ ail, and he larger is he kurosis, he faer is he disribuion. The non-normaliy of he reurn and reurn spread series jusify he examinaion on he reurn disribuion. This finding suggess ha compare o he Chinese ADRs in porfolio I, he Chinese ADRs in porfolio II are more likely o have lower reurn han heir underlying H shares basis poin accouns for 1% 116

117 4.5 Empirical ess and resuls Tess on he law of one price We nex conduc several ess o deermine wheher he reurns for ADR and heir underlying HK securiies are idenical. We firs apply -es o compare mean and Wilcoxon signed-rank es o compare median for each pair of he ADRs. Kao e al. (1991) repored no arbirage possibiliy exiss by using hese wo locaion sensiive ess. Nex, we follow Rabinovich e al (2003) o use Kolmogorov-Smirnov es and he means and variances equaliy es o examine he reurn disribuion for 15 pairs of he ADRs, and we repor our resuls in able 4.5 and 4.6 Table 4.5: Equaliy ess on reurns of he ADRs and H shares. (p value in parenheses). Symbol Two sample -es Wilcoxon signed-rank es Kolmogorov-Smirnov es Porfolio I ACH (0.9736) (0.8362) (0.115) CBA (0.9736) (0.8544) (0.010)*** LFC (0.8975) (0.8091) (0.001)*** CHL (0.9540) (0.9663) (0.369) CHA (0.9954) (0.9912) (0.000)*** CEO (0.9872) (0.8820) (0.038)** GSH (0.7748) (0.9018) (0.001)*** PTR (0.9379) (0.8866) (0.000)*** CHU (0.9066) (0.9693) (0.046)** 117

118 Porfolio II CEA (0.9741) (0.5824) (0.000)*** SNP (0.7953) (0.5416) (0.000)*** ZNH (0.9797) (0.7614) (0.032)** HNP (0.4451) (0.6383) (0.000)*** SHI (0.8844) (0.5540) (0.001)*** YZC (0.9236) (0.5285) (0.041)** Noe:*** indicaes a less han 1% significan level, ** indicaes a less han 5% significan level, * indicaes a less han 10% significan level Table 4.5 repors he es resuls. Firs we conduc a paired -es for differences in means. Column 2 conains he -saisics for he difference in means es. Based on he -saisics, we canno rejec he null hypohesis ha here is no difference in means beween he ADR and he corresponding underlying securiy reurns a 10% or lower significance level for any of he 15 ADR-HK securiy pairs. Second, in column 3, we repor resuls from a non-parameric Wilcoxon signed-rank es. On he basis of he signed rank es resuls also we canno rejec he null hypohesis on he equaliy of medians beween ADR and HK securiy reurns for any of he 15 ADR-HK securiy pairs. Third, in column 4, we repor Kolmogorov-Smirnov es for esing he null hypohesis ha he disribuions ADRs and HK reurns are idenical. In saisics, he Kolmogorov Smirnov es (he K-S es) is a goodness of fi es used o deermine wheher wo underlying one-dimensional probabiliy disribuions differ, or wheher an underlying probabiliy disribuion differs from a hypohesized disribuion, in eiher case based on finie samples. The wo-sample K-S es is one of he mos useful and general nonparameric mehods for comparing wo samples, unlike -es and he Wilcoxon 118

119 signed-rank es which are only sensiive o differences in locaion, he K-S es is sensiive o differences in boh locaion and shape of he empirical cumulaive disribuion funcions of he wo samples. As he repored es saisics, KSa shows we rejec he null hypohesis ha ADR and underlying securiy reurns disribuions are idenical a less han 10% significance level for 7 ou of 9 pairs of securiies (each ADR and is underlying HK securiy) from Porfolio I and rejec he equaliy of he reurns disribuions for all ADRs and heir underlying securiies in Porfolio II. In addiion o he differences in means and sandard deviaions in porfolio reurns as saed earlier, here we find evidence of a srucural difference beween Porfolios I and II; however, he number of securiies in each porfolio is oo small o conduc a conclusive saisical es on he difference beween he wo porfolios. Noe ha resuls of Kolmogorov-Smirnov es implying he inequaliy of wo securiies reurns is due o dispersion of reurns disribuion, since wo locaion ess -es and Wilcoxon signed-rank es canno rejec he null hypohesis. And his is consisen wih he small mean of reurn spread ha we repor in able 4.4. We hen do a join means and variance es as in Rabinovich e al (2003) based on Bradley and Blackwood (1989) who assumed a join parameric disribuion of he means and variances equaliy. Le HK r and US r denoe he reurn on H share and ADR raded a day, assume ha he reurn disribuions are ellipical and define Y = HK r - US r, X = HK r + r US, and DEVX = X - X. Then, perform he following regression. The null hypohesis ha β 0 =0 and β 1 =0 is agains he alernaive hypohesis ha a leas one of he coefficiens is differen from zero, namely he mean reurns and he reurns variances are 119

120 simulaneously equal. We repor F value of he null hypohesis in Table 4.6. Y = β 0 + β 1 DEVX + e (4) Table 4.6: F-es for join means and variance ess ( sa in parenhesis) Symbol Equaliy es Consan (ß 0 ) DEVX(ß 1 ) F-es Porfolio I ACH -4.13e -5 (-0.03) (-1.21) 1.46 CBA 1.41e -4 (0.11) (-0.30) 0.09 LFC -1.03e -4 (-0.09) 0.077**(2.25) 5.07** CHL -4.91e -5 (-0.06) 0.063***(3.05) 9.30*** CHA -3.82e -5 (-0.04) (-0.25) 0.06 CEO -1.76e -5 (-0.02) (-1.10) 1.20 GSH 2.22e -4 (0.27) ***(-3.31) 10.99*** PTR -5.56e -5 (-0.08) (0.43) 0.18 CHU -1.11e -4 (-0.12) 0.063***(2.75) 7.56*** Porfolio I CEA 3.42e -5 (0.03) ***(-8.35) 69.73*** SNP -2.32e -4 (-0.26) 0.044*(1.68) 2.84* ZNH -2.95e -5 (-0.03) **(-2.05) 4.21** HNP -5.75e -4 (-0.76) 0.034***(2.50) 6.26*** SHI 9.65e -5 (0.10) ***(-7.06) 49.84*** YZC -2.91e -4 (-0.27) (-1.00) 1.00 Noe:*** indicaes a less han 1% significan level, ** indicaes a less han 5% significan level, * indicaes a less han 10% significan level On he basis of he repored F-ess we rejec equaliy of boh means and variances 120

121 for four ou of nine securiies in Porfolio I bu five ou of six securiies in Porfolio II a less han 10% significan level. The resuls again confirm a srucural difference beween Porfolio I and Porfolio II and ha when reurns variances are considered he reurns disribuions for ADRs and H shares are no idenical. Table4.7: Summary of es resuls of Tables 4.5 and 4.6. ( Yes indicaes rejecion of he hypohesis while No indicaes null hypohesis canno be rejeced.) Symbol Ksa Wilcoxon signed-rank es Two sample -es Join means and variance ess Porfolio I ACH No No No No CBA Yes No No No LFC Yes No No Yes CHL No No No Yes CHA Yes No No No CEO Yes No No No GSH Yes No No Yes PTR Yes No No No CHU Yes No No Yes Porfolio II CEA Yes No No Yes SNP Yes No No Yes ZNH Yes No No Yes HNP Yes No No Yes SHI Yes No No Yes YZC Yes No No No 121

122 We summarize he es resuls in Tables 4.5 and 4.6 in Table 4.7, which indicaes he following. a) Sandard locaions ess are inadequae in capuring he differences beween ADRs and he underlying securiies reurns. b) The disribuions appear o be differen primarily due o differences in variances and heir ail masses (we provide Q-Q plos of normalized reurns in Graph 4.2 o show how he ail areas are differen from hose of idenical disribuions). c) There are srucural differences beween Porfolio I and Porfolio II, which lead o differences in heir reurns disribuions. This finding is appealing, because he mos obvious difference beween hese wo porfolios is wheher hese ADRs have A shares lised in China s domesic sock marke, hough here are also some differences in he indusries ha hese ADRs belong o. The addiional A shares lising gives rise o an increasing in he shareholder base, because he number of ousanding shares increase. A he same ime, he A shares are only issued and raded in domesic marke which is known as segmened wih he Hong Kong and US marke as we have inroduced in chaper 2. The srucural difference beween wo porfolios clearly ells us he invesors would give he valuaion of his addiional A shares lising, in paricular, he invesors in he US end o give negaive assessmen for i. Because he reurn spread in porfolio II are all negaively skewed, which indicaes he ADRs reurn in porfolio II have higher possibiliy o be lower han heir underlying H shares reurn. As menioned earlier, in Graph 4.2 we provide Q-Q (quanile-quanile) plos of he normalized reurns for ADR and he underlying H securiy. Q-Q plo visually checks for wheher he daa deviae from cerain disribuion, or wheher wo daa ses come from populaions wih common disribuion. A 45-degree reference line is also ploed. If he wo ses come from a populaion wih he same disribuion, he poins should fall 122

123 approximaely along his reference line. Graph 4.2: Q-Q (Quarile-Quarile) plos of ADRs and H shares reurns 1. ACH hk-r us-r CBA hk-r us-r hk-r hk-r us-r Quanile-Quanile Plo us-r Quanile-Quanile Plo 123

124 3. LFC hkr usr hkr 4. CHL usr Quanile-Quanile Plo hkr usr hkr 5. CHA usr Quanile-Quanile Plo hkr usr hkr usr Quanile-Quanile Plo 124

125 6. CEO hkr usr hkr 7. GSH usr Quanile-Quanile Plo hkr usr hkr 8. PTR usr Quanile-Quanile Plo hkr usr hkr usr Quanile-Quanile Plo 125

126 9. CHU hkr usr hkr 10. CEA usr Quanile-Quanile Plo hk-r us-r hk-r 11. SNP us-r Quanile-Quanile Plo hkr usr hkr usr Quanile-Quanile Plo 126

127 12. ZNH hkr usr hkr 13. HNP usr Quanile-Quanile Plo hkr usr hkr 14. SHI usr Quanile-Quanile Plo hkr usr hkr usr Quanile-Quanile Plo 127

128 15. YZC hkr usr hkr usr Quanile-Quanile Plo for r ADR In he Q-Q plos, he horizonal axis measures he reurn of he ADRs, usr sands, and he verical axis shows he reurn of he H shares, hkr sands for r HK. There are four fracions in each axis, which means he firs, he second, he hird, and he forh quaniles of he disribuion. The Q-Q plo describes he quaniles of he ADRs reurn agains he quaniles of he H shares reurn. By a quanile, we mean he fracion (or percen) of poins below he given value. Tha is, he 25% quanile is he poin a which 25% percen of he daa fall below and 75% fall above ha value. A 45-degree reference line is ploed auomaically by he sofware package (we use STATA). As we have already poined ou, if he wo securiies have he same disribuion, he poins should fall approximaely along his reference line. The greaer he deparure from his 45-degree reference line, he greaer of he evidence ha he reurn of he ADRs and he H shares have differen disribuions. In our 15 plos, all ADRs have he poins concenraed along he reference line beween he firs quanile and he hird quanile, bu all he ADRs have greaer deparure from he reference line a he quaniles 128

129 which is greaer han he hird quanile or smaller han he firs quanile, which means he reurn disribuion of wo securiies are quie differen a he ails. We also noice ha he reference line in some plos are no 45 degree and he inerceps is no zero, for example, ACH, CHU, CEA, and YZC, a non-45 degree line usually sands for he difference in kurosis of wo reurns. In conclusion, we find wo securiies have quie differen disribuions in heir reurns, and he difference mainly comes from he ail and higher momens. The descripive saisics of wo securiies reurn also indicaes he reurn daa are no normally disribued since all reurn series have he kurosis which is higher han 3. The equaliy ess on reurn disribuion and he descripive saisics of reurn spread clearly show a srucural difference beween he wo porfolios; we expec his difference may be due o he US invesors pessimisic aiude o he addiional A shares lising Tess on he comovemen effec on he mispricing Nex, we examine he pair-wise correlaion beween wo securiies reurn and hen he comovemen effec wih he local marke indices. We use Spearman correlaion es and Pearson Correlaion es o measure he correlaion beween each pair of he ADRs by maching he reurns during he same rading dae, he number of observaions can be accessed in able4.4. The null hypohesis is ha ρ ( r ADR, r HK ) = 0 i.e., he Chinese ADRs and underlying H shares reurns are uncorrelaed. Since ADRs are claims on cash flows generaed by heir respecive underlying shares, and he conversion mechanism beween he ADRs and he underlying shares would force he prices of wo securiies o be close o 129

130 each oher. Therefore, inuiively, one would expec ha he conemporaneous correlaions beween he wo reurns o be high (probably close o one). On he oher hand, due o he difference in rading hours ha Hong Kong marke sars 12 hours earlier han he US marke; we also expec he lead-lag correlaion beween he wo securiies o be high. Table 4.8: Pearson and Spearman correlaion es (p value in parenhesis) Symbol Spearman correlaion ( r, r ) ADR ACH 0.722*** (0.000) HK Pearson correlaion ( r, r ) ADR 0.766*** (0.000) HK Spearman correlaion ADR ( r ) r 1, 0.242*** (0.000) HK Pearson correlaion ADR ( r ) r 1, 0.274*** (0.000) HK CBA 0.772*** (0.000) 0.805*** (0.000) 0.151*** (0.000) 0.151*** (0.000) LFC 0.687*** (0.000) 0.742*** (0.000) 0.194*** (0.000) 0.232*** (0.000) CHL 0.679*** (0.000) 0.668*** (0.000) 0.263*** (0.000) 0.333*** (0.000) CHA 0.659*** (0.000) 0.711*** (0.000) 0.202*** (0.000) 0.237*** (0.000) CEO 0.621*** (0.000) 0.661*** (0.000) 0.283*** (0.000) 0.288*** (0.000) GSH 0.495*** (0.000) 0.494*** (0.000) 0.202*** (0.000) 0.200*** (0.000) PTR 0.625*** (0.000) 0.696*** (0.000) 0.239*** (0.000) 0.253*** (0.000) CHU 0.629*** (0.000) 0.653*** (0.000) 0.260*** (0.000) 0.300*** (0.000) CEA 0.539*** (0.000) 0.522*** (0.000) 0.239*** (0.000) 0.348*** (0.000) SNP 0.676*** (0.000) 0.701*** (0.000) 0.183*** (0.000) 0.231*** (0.000) 130

131 ZNH 0.655*** (0.000) 0.664*** (0.000) 0.156*** (0.000) 0.229*** (0.000) HNP 0.701*** (0.000) 0.702*** (0.000) 0.222*** (0.000) 0.289*** (0.000) SHI 0.520*** (0.000) 0.528*** (0.000) 0.330*** (0.000) 0.402*** (0.000) YZC 0.613*** (0.000) 0.606*** (0.000) 0.185*** (0.000) 0.206*** (0.000) Noe:*** indicaes a less han 1% significan level, ** indicaes a less han 5% significan level, * indicaes a less han 10% significan level In Table 4.8 we repor Pearson and Spearman correlaion coefficiens beween ( r, r ) and beween ( ADR HK ADR r 1, HK r ), and he corresponding significance levels beween ADR and he underlying securiy reurns. All he ADRs have significan posiive correlaion wih heir underlying H shares wih regard o he conemporaneous and lead-lag relaion. And he value of Spearman es is a bi lower han ha from he Pearson es, bu boh ess are consisen in heir level of significance and sign. One observaion from his able is he conemporaneous correlaions are no as high or close o one as inuiion may have prediced. The conemporaneous correlaions of Spearman es range from for GSH o for CBA, he lead-lag correlaion of Spearman es range from for CBA o for SHI. These resuls are consisen wih he findings of Kao e al. (1991). Alhough Kao e al. (1991) declaimed ha heir findings suppor he law of one price; hey also demonsraed ha he reurns of he ADRs and he underlying socks are neiher perfecly, nor even near perfecly correlaed, since he correlaions are no close o one, and hey suggesed he non-overlapping rading hour is a leas a parial explanaions for his. Therefore, we exend he research by Kao e al. (1991), and follow he approach of Gagnon and Karolyi (2004). We presen our resuls of he ime series model described 131

132 in equaion (1) in able 4.9. Specifically, we use S&P 500, ^HIS, and ^SHA as hree marke indices respecively. S&P 500 is a marke capializaion-weighed index ha racks he daily oal reurn performance of 500 common socks of large capializaion companies ha are lised on he NYSE, AMEX, and NASDAQ. The S&P 500 accouns for abou 64% of he marke value of shares lised a he hree exchanges. ^HSI is Hang Seng Index, which is a free floa-adjused marke capializaion-weighed sock marke index in Hong Kong. I is used o record and monior daily changes of he larges companies of he Hong Kong sock marke and is he main indicaor of he overall marke performance in Hong Kong. These 45 companies represen abou 67% of marke capializaion of he Hong Kong Sock Exchange. ^HSI is he mos represenaive index of Sock Exchange of Hong Kong (SEHK), and is acive from ^SHA is he index of all A-shares on he Shanghai Sock Exchange (SHSE), and is acive from The reason no o use ^SSEC, he composie index of SHSE, is because ^SSEC also includes all B-shares on he SHSE; however A-shares and B-shares are wo segmened markes. The able 4.9 bellow repors summary saisics for ime-series regressions of he Chinese ADRs and he underlying H shares reurn differences on he coemporaneous and up o wo lagged reurns on he US marke index, he underlying Hong Kong marke index, and he home marke index for he ADRs in porfolio II. The sample period ends on Ocober 20, 2006, begins on various daes according o individual securiies lising hisory, he number of he observaions can be found in able 4.4. We perform he following model for he 15 pairs of he ADRs: ADR r - r HK = α US 0 US US HK HK + β i R + i + β i R + i + ε (1) i= 2 0 i= 2 132

133 Table 4.9: Resuls of ime series regression analysis Porfolio I ACH CBA LFC CHL CHA CEO GSH PTR CHU α (0.14) (0.07) (0.00) (0.07) (0.07) (0.11) (0.50) (-0.02) (-0.01) US 0.278*** 0.207*** 0.868*** 1.002*** 0.812*** *** 0.388*** 0.428*** 1.001*** β (11.55) (9.45) (11.51) (33.17) (16.87) (-4.50) (7.61) (10.32) (20.61) US *** *** *** *** *** * *** *** *** β 1 (-5.88) (-3.23) (-8.78) (-23.55) (-10.27) (-1.69) (-5.70) (-8.79) (-17.83) US * ** 0.197*** 0.254*** β 2 (0.56) (-0.35) (1.65) (-0.31) (-2.23) (3.05) (4.42) (0.32) (-0.33) HK *** *** *** *** *** 0.788*** *** *** β (-5.09) (-2.98) (-3.78) (-13.47) (-4.73) (8.60) (0.10) (-3.03) (-8.95) HK * * *** *** β 1 (-0.28) (-1.14) (-1.74) (0.83) (-1.68) (-4.85) (-6.76) (-1.15) (-0.98) HK ** ** * β 2 (0.41) (0.97) (1.40) (0.97) (2.15) (-0.90) (1.98) (1.25) (1.80) Adj % 8.84% 29.6% 52.8% 34.84% 20.92% 6.58% 15.94% 45.57% R 2 Porfolio II CEA SNP ZNH HNP SHI YZC α (0.02) (0.08) (-0.14) (0.10) (0.41) (0.48) US 0.148** 0.208*** 0.459*** 0.521*** 0.205*** 0.258*** β (2.44) (10.57) (8.26) (12.43) (7.35) (3.41) US *** *** *** *** *** *** β 1 (-7.01) (-7.73) (-8.05) (-7.32) (-7.16) (-3.46) US ** *** β 2 (1.08) (-0.63) (2.19) (0.74) (2.76) (0.95) HK *** *** β (1.28) (-3.22) (0.42) (-3.85) (0.48) (-0.16) HK *** *** *** *** β 1 (-8.69) (-1.34) (-4.91) (-3.19) (-10.60) (-0.92) HK *** β 2 (1.25) (0.40) (0.42) (1.02) (1.58) (1.40) SH *** β (0.59) (-1.01) (2.48) (-0.59) (0.39) (1.28) SH * β 1 (0.09) (0.52) (-0.28) (-0.54) (1.78) (-0.94) SH *** β 2 (-1.47) (-1.09) (-0.95) (2.48) (-1.26) (-0.81) Adj. 7.06% 14.48% 8.68% 11.37% 7.46% 1.32% R 2 Noe:*** indicaes a less han 1% significan level, ** indicaes a less han 5% significan level, * indicaes a less han 10% significan level In able 4.9, we presen summary saisics of ime series esimaes from he regression model described in Equaion (1) for he 15 pairs of he ADRs grouped ino wo porfolios in our sample. We find ha for all 15 pairs of ADRs, reurn differenials exhibi inercep coefficiens nearly o be zero. Wih regard o he conemporaneous comovemen 133

134 effec, we find he posiive and significan exposure o he US marke index ( β US ) for all ADRs bu CEO, while for he esimaion of he coinciden underlying marke index ( β HK ), we find significan negaive relaion in en ADRs. Wih respec o he lagged comovemen effec; we find negaive and significan exposure o he US marke index wih one lag ( β US 1 ) for all ADRs, and negaive and significan exposure o he underlying Hong Kong marke index wih one lag ( β HK 1 ) for eigh ADRs. The exposure o each marke index wih wo period lags ( US β 2, β HK 2 ) is less han he exposure o he conemporaneous and one period lagged marke index, we find posiive significan esimaion for five ADRs in erms of β US 2, and posiive significan esimaion for four ADRs in erms of β. We believe he relaively smaller in magniude and he less in HK 2 significan esimaions of US β 2, β sugges ha he comovemen effec is a shor-run HK 2 effec, and his is also consisen wih he conclusion in De Jong e al. (2003). Second, while he effecs of he US and Hong Kong marke index reurns on securiy reurns are consisenly significan for mos of he ADRs reurn differenials, he excepion is for CEO which shows an opposie marke bea esimaion wih negaive correlaion wih he US marke index bu posiive correlaion wih he Hong Kong marke index. We also noe ha he evidence of isolaed home counry effec is insignifican. We only find significan Shanghai marke bea in hree ADRs, namely ZNH, HNP and SHI. Our sample is oo small and he number of firms displaying such anomalies is even smaller and hus we refrain from generalizing he excepions; however, we noe ha similar evidence of scaered securiy specific effecs are documened in Alberon e al (2001) and Chakrovary (2005). 134

135 Third, our resuls of he conemporaneous coefficien of he US and Hong Kong marke indices are consisen wih De Jong e al. (2003) and Gagnon and Karolyi (2004), hey repored significan posiive relaions beween reurn differenials and he US marke index and significan negaive relaions beween reurn differenials and he home marke index a a conemporaneous level. This finding is also in line wih our predicion in secion However, unlike De Jong e al. (2003) and Gagnon and Karolyi (2004) ha hey did no find any significan esimaion wih regard o he lagged marke indices, while we find for mos of he Chinese ADRs, he reurn differenials are significanly negaive wih he one period lagged US and Hong Kong marke indices. I is no difficul o undersand a negaive relaion wih he lagged Hong Kong marke index, for insance, a posiive shock in he Hong Kong marke a day 0 will lead o a rise in he H shares reurn a day 1 and herefore a drop in he reurn differenials a day 1. The consisenly significan negaive relaions wih he lagged US marke ( β US 1 ) for all he ADRs seems odd. However, we find similar evidence from Kim e al. (2000), who sudied he dynamic relaion beween ADRs reurn and he S&P 500 in a long horizon. They found he ADRs response o he innovaion of he S&P 500 is large, posiive and highly significan a day 0, and followed by a large, significan negaive price response on day 1. They argued ha i is because ADRs are clearly overreacing o innovaions in he S&P 500 Index. Therefore, our findings offer new evidence for he exisence of mispricing of he ADRs and new aribuions o he limis of he arbirage, ha mispricing of he ADRs is no only caused by he conemporaneous comovemen effec bu also he lagged comovemen effec wih he local marke index. We believe his finding will be very useful for hedge funds managers o design arbirage sraegy, since shor-selling is no resriced in boh 135

136 he US and Hong Kong marke. Finally, we also noice an ineresing paern of he esimaed beas ha are quie differen beween wo porfolios. We hen urn our aenion o he value of he beas on he porfolio level. We summarize he mean of each coefficiens of he esimaion in equaion (1), and perform F es; our null hypohesis is ha he esimaed beas for he US and Hong Kong marke risk are joinly equal in boh mean and variance beween wo porfolios, we repor our resuls in able Table F es on join equaliy of mean and variance beween wo porfolios Mean Variance F saisics (p value) No. of significan esimaions Porfolio I Porfolio II Porfolio I Porfolio II US β ** (0.016) US β ** 1 (0.038) US β * 2 (0.08) HK β *** (0.00) HK β * 1 (0.08) HK β ** 2 (0.02) Porfolio I (+) 8 (-) 1 Porfolio II (+) 6 (-) 9 (-) 6 (-) 1 (+) 3 (-) 7 (+) 1 (+) 2 (-) 2 (-) 4 (-) 4 (+) 3 (+) 1 Noe:*** indicaes a less han 1% significan level, ** indicaes a less han 5% significan level, * indicaes a less han 10% significan level We repor mean and variance for each correlaion coefficiens for wo porfolios respecively, he F saisics wih he p value are repored, we also repor he number of significan coefficiens wih specifying posiive or negaive correlaion coefficiens, for example, (+) 6 means we ge 6 significanly posiive coefficiens. 136

137 Ineresingly, able 4.10 is clearly showing srucural difference beween wo porfolios. The F saisics rejec he equaliy of mean and variance beween wo porfolios for all esimaed beas. Bearing in mind ha in able 4.4 which summarizes he descripion of he reurn spread, we find ha all ADRs in porfolio II, bu only four ou of nine ADRs in porfolio I have negaively skewed ail. Once again, in secion 4.5.1, he es on he law of one price, we also find wo porfolios have differen paerns in he reurn disribuion. Therefore, we may aribue one of he reasons for he difference in wo porfolios o he various magniude comovemen effecs of he wo markes. Furhermore, as we can see from able 4.10, wih regard o he beas on he US marke index; he means are 0.519/0.299, /-0.262, and 0.054/0.071 for wo porfolios respecively, while wih regard o he beas on he Hong Kong marke index, he means are /-0.002, /-0.124, and 0.051/0.031 for wo porfolios respecively. This indicaes he ADRs expose o higher sysemaic risk of he US marke han ha of he Hong Kong marke, and his is same as he findings in Gagnon and Karolyi (2004). In conclusion, he wo seps invesigaions on he exisence of he ADRs mispricing show ha he significan posiive correlaions beween pair-wised wo securiies reurns have limiaion in he argumen ha he law of one price is applicable o he ADRs and heir underlying shares. Alhough we find significan posiive correlaed ADRs reurn and H shares reurn, and similar magniude in he correlaion coefficiens like Kao e al. (1991), we sill find evidence of he exisence of he mispricing beween wo securiies. We aribue o he conemporaneous comovemen effec wih he local marke index (Gagnon and Karolyi, 2004), as well as he US based invesors prolonged 137

138 over reacion o he innovaions in he US marke (Kim e al. 2000) Tes on he liquidiy effec We will now calculae wo liquidiy proxies, liq = log( vol ), ILLIQ = r / vol for ADRs and H shares respecively. Boh ADRs and H shares are frequenly raded in wo markes; he none-rading days accoun for less han 1% of he oal sample period for mos of he ADRs and H shares. We exclude he daa wih zero rading value o avoid he unnecessary exaggeraed variance, and since only a handful of daa has been deleed, we believe i will no change he resuls of our ime series regression esimaion. We repor he descripive saisics of wo liquidiy proxies and he correlaion coefficien beween wo liquidiy measures for boh he ADRs and H shares in able Table 4.11: Descripive saisics of liquidiy proxies Symbol ACH [2600.hk] CBA [1114.hk] LFC [2628.hk] CHL [0941.hk] CHA [0728.hk] CEO [0883.hk] GSH [0525.hk] Obs. liq Log(volume) mean Sd. Dev mean 7.12e e e e e e e e e e e e e e-07 ILLIQ Sd. Dev 3.92e e e e e e e e e e e e e e-07 Corr. of liq and ILLIQ Corr. of liq and (ADR) (HK) *** *** *** *** *** *** *** *** *** *** *** *** *** *** ILLIQ 138

139 PTR e e *** *** [0857.hk] e e-08 CHU e e *** *** [0762.hk] e e-10 CEA e e *** *** [0670.hk] e e-09 SNP e e *** *** [0386.hk] e e-07 ZNH e e *** *** [1055.hk] e e-07 HNP e e *** *** [0902.hk] e e-08 SHI e e *** *** e e-07 YZC e e *** *** e e-07 Noe:*** indicaes a less han 1% significan level, ** indicaes a less han 5% significan level, * indicaes a less han 10% significan level We hen repor summary saisics for ime-series regressions of he liquidiy effec on reurn spreads in able The sample period ends on Ocober 20, 2006, begins on various daes according o individual securiies lising hisory, he number of he observaions can be accessed in able This model is esed based on daily daa. We perform he following model for he 15 pairs of he ADRs, ILLIQ is scaled up by muliplying 10 5, -saisics are repored in parenhesis. ADR HK ADR ADR HK HK r r = α + β1 ILLIQ + β2 ILLIQ + ε (2) ADR HK ADR ADR HK HK r r = α + β3 liq + β4 liq + ε (3) 139

140 Table 4.12: Liquidiy effecs. Symbol ADR liq HK liq ADR ILLIQ HK ILLIQ Adj R 2 ACH 0.008*** *** 7.93% (2.64) (-3.07) 0.002** % (2.14) (-0.97) CBA 0.006* *** 2.90% (1.82) (-3.50) % (1.44) (-1.54) LFC 0.003*** % (2.31) (-1.41) *** 2.69% (0.58) (-2.32) CHL 0.003** % (1.93) (-0.61) 0.195*** % (3.29) (-1.15) CHA 0.007*** *** 3.83% (2.25) (-2.14) 0.021* ** 3.31% (1.79) (-2.16) CEO 0.004** *** 5.02% (2.10) (-4.17) 0.065* * 3.45% (4.07) (-3.17) GSH 0.007*** *** 5.13% (2.78) (-2.85) * 1.25% (0.04) (-1.84) PTR 0.004** ** 5.05% (1.90) (-1.91) % (0.26) (-1.49) CHU 0.005*** * 3.45% (1.97) (-2.55) % (1.26) (-0.66) CEA 0.007*** % (2.80) (-1.03) % (-0.45) (1.72) 140

141 SNP % (0.93) (-1.10) % (1.46) (0.21) ZNH % (1.34) (-0.27) % (1.07) (-1.32) HNP 0.007* * 2.21% (1.88) (-1.92) * 0.87% (-0.28) (-1.87) SHI 0.009*** *** 6.33% (3.39) (-2.83) * 1.20% (1.28) (-1.83) YZC 0.004*** *** 5.12% (2.66) (-2.49) % (-0.59) (1.07) Noe:*** indicaes a less han 1% significan level, ** indicaes a less han 5% significan level, * indicaes a less han 10% significan level The resuls in able 4.12 are consisen wih our expecaions regarding he relaion beween he reurn differenials and he rading volume as well as illiquidiy. By employing rading volume as a measure of liquidiy risk, we predic a posiive relaion beween liquidiy risk and reurn. An increase in he liquidiy risk of he ADRs will lead o a rise in he ADRs reurn, and herefore a rise in reurn spread. Likewise, an increase in he liquidiy risk of he H shares will lead o a rise in he H shares reurn, and herefore a drop in reurn spread. We find he signs of he esimaed beas on he ADRs rading volume are consisenly posiive wih reurn spread, and H shares rading volume are consisenly negaive. The coefficiens of rading volume are significan for 10 pairs of ADRs and H shares. Wih he res of 5 pairs of he 141

142 ADRs and H shares, we only find significan coefficiens in ADRs rading volume for hree ADRs, namely LFC, CHL, and CEA. Furher, we noice he magniude of he esimaed correlaion coefficiens ranges from for SHI as he ADRs o for SHI as he underlying H shares. The adjused R 2 ranges from 2.21% for HNP o 7.93% for ACH. Wih regard o he illiquidiy measure, as we predic in he previous secion ha here should be a posiive relaion beween illiquidiy and reurn. An increase in he illiquidiy of he ADRs will lead o a rise in he ADRs reurn, and herefore a rise in reurn spread. Likewise, an increase in he illiquidiy of he H shares will lead o a rise in he H shares reurn, and herefore a drop in reurn spread. We find for 12 pairs of he ADRs and H shares, he signs of he esimaed correlaion coefficiens of he ADRs illiquidiy are consisenly posiive, and ha of he H shares illiquidiy are consisenly negaive. Bu in hese 12 pairs of he ADRs, he coefficiens are significan only in 2 pairs, namely CHA and CEO, 8 pairs of ADRs have significan coefficien in eiher ADRs illiquidiy or H shares illiquidiy. And he adjused R 2 ranges from 0.78% for YZC o 3.45% for CEO. The illiquidiy measure seems o have less explanaory power han rading volume. We expec illiquidiy o be a more noisy measure of liquidiy han he rading volume since i is measured as daily absolue reurns per uni of volume, as we know daily ime series daa usually has higher variance han weekly or monhly ime series daa, and high variance may lower he significan level of he esimaion. Therefore, we have demonsraed ha apar from he comovemen effec from 142

143 local marke index, liquidiy effec can also explain he mispricing of he ADRs. However, from he relaively small R 2 of he liquidiy effec regression, we believe he comovemen effec would dominae over he liquidiy effec Srucural change As far as he empirical invesigaions have gone hrough, we now have a clear image abou he arbirage possibiliy of he Chinese ADRs. We have shown ha he difference in he reurn disribuion beween he ADRs and he H shares lead o he possible reurn differenials and his mispricing is persisen for an exended period because he marke-based, informaion-based, and rading-based barriers hamper arbirage aciviy. We have found srong evidence of conemporaneous and lagged comovemen effec from he local marke index; we also found obvious evidence for liquidiy risk effec. Specifically, we have found ha wo porfolios have apparenly differen paerns in he comovemen effec. The mos disinguishing characerisics of hese wo porfolios is while one porfolio is wih addiional A shares lised in Shanghai Sock Exchange, he oher is wihou. We have also found some isolaed comovemen effec from Shanghai sock marke in he comovemen effec examinaion. This finding addresses he quesion ha how does he innovaion in Shanghai sock marke influence he Chinese ADRs lised in he NYSE? As we have discussed in chaper 2, a se of imporan reformaion ook place around 2003 in China. On November 5,

144 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, and he imporan non-radable shares reform saring from he end of For his, we believe ha he year 2003 o be a breaking poin o es if here is any srucural change in he comovemen effec from he domesic marke. On he oher hand, observing he lising daes of he Chinese ADRs as indicaed in Graph 4.1, more han 50% (8/15) ADRs were lised beween 2000 and We believe a reasonable hypohesis for his srucural shif in 2000 may be he marke collapse in he US, paricularly he IPO marke, which led some Hong Kong firms o offer heir securiies o he US invesors as alernaive invesmen opions. Therefore, we decide o sudy furher abou he impac from he marke innovaions in erms of he comovemen effec. We selec wo breaking poins, he year of 2000 and 2003, he former dae sands for he innovaions in he US marke, and he laer dae represens he reformaions in he China s sock marke. Economerically, we es his srucural break/shif via a Chow es ha requires he break periods o be known a priori. Chow es is o es he equaliy of regression coefficiens over wo sample periods condiional on he equaliy of error variances. I is commonly used o es for a srucural break. The model in effec uses an F-es o deermine wheher a single regression is more efficien han wo separae regressions involving spliing he daa ino wo sub-samples. We will repor summary saisics for srucural change es in able The 144

145 sample period ends on Ocober 20, 2006, begins on various daes according o individual securiies lising hisory, he number of he observaions can be found in able 4.4. We divide he sample period ino hree sub-periods, before 2000, , and afer 2003, for he ADRs lised before 2000, he sub-periods will be hree, while for he ADRs lised afer 2000, he sub-periods will be wo. Three ADRs, namely LFC, CHA, and CEO are excluded from he srucural change es, because heir lising dae is in 2003, which makes our observaion number for he period of pos-2003 oo limied. We perform he following model for he 15 pairs of he ADRs, for he ADRs in porfolio II, we in addiion include he marke index of Shanghai: ADR r - r HK = α US 0 US US HK HK + β i R + i + β i R + i + ε i= 2 0 i= 2 Table 4.13: Srucural change Porfolio I symbol ACH CBA CHL Sub-period US 0.163*** 0.387*** 0.092*** 0.343*** 1.04*** 1.03*** 1.03*** β (4.78) (11.53) (2.83) (11.02) (14.98) (19.34) (25.07) β β US 1 US 2 HK β β HK ** (-2.17) (1.04) (-1.31) (-1.44) *** (-6.97) (-1.52) *** (-5.56) (0.47) (-0.10) (1.09) (-1.51) (-0.51) *** (-4.82) *** (-2.24) ** (-2.25) (-2.82) *** (-9.91) (-0.91) *** (-8,58) (1.26) *** (-13.53) (1.19) *** (-6.85) (-0.55) *** (-15.65) ** (-1.97) *** (-6.13) (-0.64) HK β 2 (-1.32) (1.30) (-0.66) (0.44) (1.40) (-0.49) (1.26) Adj. R % 21.85% 3.5% 16.66% 50.52% 50.82% 56.22% Chow 8.57*** 9.76*** 5.34*** symbol GSH PTR CHU Sub-period

146 US β β β US 1 US 2 HK β β HK *** (4.07) *** (-4.21) *** (-4.16) ** (-2.20) *** (-6.98) 0.237*** (4.34) (-1.26) (0.64) *** (-3.51) (-0.39) 0.501*** (7.27) *** (-3.96) (1.02) *** (-2.68) ** (-1.97) 0.271*** (6.03) (-6.16) (1.14) (-0.55) (0.20) 0.735*** (12.41) *** (-6.77) (-0.97) *** (-4.18) *** (-2.75) 1.03*** (18.21) *** (-12.06) (0.26) *** (-6.55) (-0.61) 0.95*** (15.82) *** (-10.70) (-1.04) *** (-5.44) (-0.79) HK β 2 (0.57) (1.54) (1.09) (0.61) (-1.34) (0.89) (0.73) Adj. R % 5.55% 9.72% 13.59% 24.01% 50.63% 34.65% Chow 24.54*** 8.97*** 7.89*** Porfolio II symbol CEA SNP Sub-period US 0.244*** 0.087*** 0.145*** 0.163*** 0.289*** β (3.28) (3.31) (4.75) (6.15) (11.41) β β US 1 US 2 HK β β β HK 1 HK 2 SH β β β SH 1 SH *** (-5.91) (1.08) *** (-3.82) *** (-7.29) (0.11) * (-1.71) (-0.31) (-1.46) (-0.26) (0.64) *** (-5.96) (0.73) (1.03) (-1.53) (0.90) (-1.10) *** (-3.64) (0.96) *** (-3.56) (1.23) (-1.17) (-0.54) (-0.17) (0.77) *** (-4.72) (-0.10) * (-1.69) (-0.29) (-0.72) (-0.08) (0.72) (-1.40) *** (-6.91) (-0.39) *** (-5.42) ** (-2.20) (1.16) * (-1.86) (0.25) (-0.02) Adj. R % 8.44% 7.24% 12.07% 23.33% Chow 15.87*** 16.02*** Symbol ZNH HNP Sub-period US 0.399*** 0.479*** 0.526*** 1.101*** 0.269*** 0.487*** β (2.05) (8.15) (7.55) (8.32) (5.15) (8.45) 146

147 β β US 1 US 2 HK β β β HK 1 HK 2 SH β β β SH 1 SH *** (-4.30) 0.605*** (2.90) *** (-3.35) *** (-5.13) (-1.02) (-0.26) (-0.61) (-0.32) *** (-4.49) (0.33) *** (-3.43) (-0.87) (-1.56) (0.15) (0.55) (-1.42) *** (-3.53) * (-1.82) *** (-4.57) (1.33) (0.95) (0.70) (-0.19) (0.01) *** (-5.32) (-0.57) (-1.29) (-1.51) (-0.36) (-0.18) * (-1.84) (-2.48) *** (-2.80) (-0.03) ** (-1.96) ** (-1.94) (1.48) (-0.49) (0.92) (0.17) *** (-5.72) (0.91) *** (-3.88) (-0.07) *** (-2.58) * (-1.84) (0.34) (0.38) Adj. R % 14.22% 10.85% 22.33% 7.54% 14.22% Chow 6.98*** 7.05*** Symbol SHI YZC Sub-period US 0.177*** 0.173*** 0.301** ** 0.651*** β (3.36) (6.45) (10.19) (1.02) (2.02) (7.25) β β US 1 US 2 HK β β β HK 1 HK 2 SH β β β SH 1 SH *** (-6.88) 0.232*** (4.02) *** (-3.26) *** (-9.77) (1.34) (1.15) (0.95) (-0.99) (-0.97) (-1.34) *** (-3.89) (1.01) (-0.76) *** (-2.44) (1.29) (-0.21) *** (-4.69) ** (-2.09) *** (-4.22) (-0.78) (0.94) ** (-2.05) (0.41) (0.17) * (-1.78) (0.58) (-2.47) (-1.57) (-1.54) (0.92) (-1.19) (-0.38) (-0.24) (1.24) *** (-3.69) (0.22) (-1.02) * (-1.71) (-0.81) (0.88) *** (-4.30) (-1.01) *** (-2.54) (-1.20) (0.47) * (-1.72) (0.44) (0.13) Adj. R % 10.10% 16.72% 3.87% 3.29% 9.20% Chow 10.62*** 10.06*** Noe:*** indicaes a less han 1% significan level, ** indicaes a less han 5% significan level, * indicaes a less han 10% significan level 147

148 Table 4.13 conains he parameer esimaes from he regression model in equaion (1) and he corresponding Chow es saisic for he following wo sub periods: prior o 2003 and pos 2003, or hree sub-periods: prior o 2000, , pos 2003, for he ADRs where applicable. The Chow ess are saisically significan a less han 1% level for all ADRs. I clearly indicaes muliple srucural shifs around he year of 2000 and 2003 during he whole sample period, which causes he regression parameers o significanly differ in magniudes from one period o anoher. This poins o he obvious unreliabiliy of pooled esimaes since he regression coefficiens seem o be non-saionary. The parameer esimaes for each sub period provide a narraive for a dynamic relaion beween reurns spread and he marke indices. The over arching heme from able 4.13 is ha he regression coefficiens vary more wih ime han wih respec o models. Firs, due o differen lising hisory of hese ADRs, some ADRs lised before 2000, some lised afer 2000, so he observaion of he srucural change around 2000 is limied. However, for he seven ADRs which were lised before 2000, wo in he porfolio I (namely CHL, GSH) and five in he porfolio II (namely, CEA, ZNH, HNP, SHI, YZC), we find excep for CHL, all he oher six ADRs have a drop in heir correlaion coefficiens wih conemporaneous US marke reurn during he sub-period of This finding demonsraes our expecaion as selecing 2000 o accoun for he US marke collapse around I shows when he US marke had negaive shock, he ADRs comovemen effec wih he US marke decrease. 148

149 Second, we find he comovemen effec wih he underlying Hong Kong marke varies o a fairly large exen. We show ha in porfolio I, hree ADRs, namely, ACH, CBA, and PTR, do no have significan comovemen effec wih he Hong Kong marke before And he oher hree ADRs in porfolio I (GSH, CHU, and CHL) slighly decrease in he correlaion coefficiens wih Hong Kong marke reurn afer For porfolio II, hree ADRs (CEA, ZNH, and YZC) have a decreasing rend in he comovemen effec wih Hong Kong marke reurn, while he oher hree ADRs (SNP, HNP, and SHI) have an increasing rend in he comovemen effec wih Hong Kong marke reurn. We do no observe a clear changing movemen in he comovemen effec wih Hong Kong marke reurn around 2003, in spie of our expecaion of an indirec impac ransferring from China s sock marke o he Hong Kong sock marke. Third, for he porfolio II, we include Shanghai marke reurn in heir regression funcions. And we find he comovemen effec wih Shanghai marke index exiss only conemporaneously, which may sugges he impac from Shanghai marke diminish quickly. For he six ADRs in porfolio II, we find excep for ZNH, he oher five of hem have significan negaive coefficien wih he conemporaneous comovemen effec wih Shanghai index. Furher, wo of hese ADRs (HNP and SNP) have significan correlaion wih Shanghai marke only afer 2003, and wo of hem (SHI and YZC) have significan correlaion wih Shanghai marke afer 2000, and he coefficiens for he sub-period are bigger han ha for he sub-period pos-2003, finally, one ADR (CEA) has significan correlaion coefficien wih 149

150 Shanghai marke only for he sub-period These findings are isolaed, so ha i is difficul o claim wheher he innovaions of he China s sock marke have a clear paern of impac on he Chinese ADRs. From his srucural change es, we find he comovemen effecs wih he US marke dominae in each sub-period, and mos of hese ADRs have a shrink in he comovemen effec wih he US marke for he period of , his jusifies our expecaion abou he US marke collapse in However, he impacs from he innovaions of China s domesic marke do no show a clear paern for he period of pos This may sugges insignifican marke impac eiher direcly from Shanghai or indirecly from Hong Kong Conclusion We sudy reurns and reurns spreads on Chinese ADRs lised wih primary lising in Hong Kong sock exchange. We compare reurns and reurn disribuions on he Chinese ADRs and heir underlying H shares, by applying boh he locaion-sensiive saisical ess and disribuion-sensiive saisical ess, we find alhough we canno rejec he equaliy in he locaions (means, medians) of wo securiies reurn series, we rejec he equaliy in he disribuions for mos of he ADRs in our sample. This finding is consisen wih boh Kao e al. (1991) and Rabinovich e al (2003), hough hese wo imporan papers make conradicory conclusions wih regard o he issue of he Law in he ADRs. Recenly developed heory abou he financial marke, such as 150

151 Copula weighed porfolios, indicae some inernaional financial insiuions, such as hedge funds, can gain profi in he higher momens deviaion of he cross-lised securiies, so our finding is of imporance for he inernaionally invesmen sraegies. Furher we find he reurn spread (price differenial) of he Chinese ADRs is affeced by he comovemen effec. Our findings are no only consisen wih ha of Gagnon and Karolyi (2004) who repored he significan conemporaneous comovemen effec, bu also conribue o he lieraure ha we in addiion find lagged comovemen effec. Our finding also suppors Kim e al. (2000) who found he ADRs response o he innovaion of he S&P 500 is large, posiive and highly significan a he day 0, and followed by a large, significan negaive price response on day 1. One of he ineresing findings is ha wo porfolios are clearly differen in erms of he comovemen effecs, as well as reurn disribuions. The ADRs in porfolio II which lis A shares in Shanghai have lower reurns han he ADRs in porfolio I. We believe i is due o A shares lising increased shareholder base ha decreased he ADRs reurn, as explained by 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 his jusifies he implici impac of he domesic marke. On he oher hand, unlike he ADRs in porfolio I, reurn spreads of he ADRs in porfolio II are all negaively skewed, his indicaes wo porfolios have srucural break in erms of reurn disribuion. Furher, he ADRs in porfolio I have larger magniude of he comovemen effec han he ADRs in porfolio II. Finally, we have also invesigaed illiquidiy effec and liquidiy risk on he 151

152 reurn spread. We measure liquidiy risk by rading volume and illiquidiy by Amihud s ILLIQ. The illiquidiy effec is less significan han he liquidiy risk, and hough we find liquidiy is one of he facors in deermining reurn spread, i is a secondary effec compared o he comovemen effec. 152

153 Chaper 5 Volume-Volailiy in Dual Markes: Lessons from he Chinese ADRs Inroducion The findings of previous chapers lead o a furher invesigaion on he price difference beween he Chinese ADRs and heir idenical underlying H shares in his chaper. We have shown he differen prices of wo securiies can be explained by he sysemaic comovemen effec of he local marke, and our findings are consisen wih he findings of Gagnon and Karolyi (2004). The comovemen effec is caused by informaion-based facors such as he degree of synchronizaion of he common movemen beween he ADRs marke and he underlying marke, he exisence of asymmery of informaion beween insiders and oher shareholders. From he viewpoin of marke microsrucure heory, price is a funcion of he inensiy of informaion arrivals. As posied in O Hara (1995:153) ha prices are condiional expeced values, he price a each poin reflecs all publicly available informaion. Anderson (1996) saed ha price movemens are caused primarily by he arrival of new informaion and he process ha incorporaes his informaion ino marke prices. For he Chinese ADRs and heir underlying H shares, due o he non-synchronisic rading hours, he new informaion, which is expeced o be equally affecing he price of wo securiies, however arrives a wo markes a differen imes, hus he price adjusmen process o he new arrival of informaion may differ 153

154 beween he wo markes. And he reason of he differen price adjusmen process may sem from he non-synchronisic rading hours o he issues of he dynamic informaion flow across markes, and how marke paricipans learn from marke informaion. There are a number of facors which would ake par in his price adjusmen process, for example he rader s risk preferences and endowmens, he naure and exen of uncerainy, and he marke srucure iself (O Hara, 1995: 155). We believe any differences of hese facors beween he wo markes could lead o various price adjusmen processes. As analysed and repored in chaper 2, he marke microsrucures of he NYSE and SEHK are differen. NYSE is a hybrid marke wih combining dealer and aucion rading mechanisms where marke makers play a very imporan role in providing liquidiy. On he conrary, SEHK has adoped a coninuous aucion rading mechanism where individual raders pu rading orders hrough an elecronic rading board, namely Auomaic Order Maching and Execuion Sysem (AMS), and very limied numbers of marke makers exis in he marke. Differen rading mechanisms of wo markes give rise o differen kinds and proporions of marke paricipans, for example, in he NYSE, marke paricipans are composed of informed raders, marke makers, and uninformed raders, boh informed raders and uninformed raders would rade wih marke makers; in he SEHK, however, marke paricipans are mainly eiher informed raders or uninformed raders who rade among hemselves hrough elecronic rading board. The informed raders have privae informaion abou he sock s fuure dividends, while he uninformed raders 154

155 exrac informaion from realized dividends, prices and public signals. The uninformed invesor rade for non-informaional reason and his non-informaional rading are also known as noise rading. The differen risk preference and endowmens of he invesors in he US and Hong Kong marke leads o differences in noise rader risk in wo markes which hampers professional arbirageurs o earn arbirage profi beween wo securiies, and i gives rise o a persisen price discrepancy beween he Chinese ADRs and H shares, which is known as he comovemen effec. From he marke microsrucure perspecive, he price adjusmen process is revealed by rading volume, as Epps and Epps (1976) argued ha increase in rading volume is associaed wih he exen o which raders disagree on a sock s price which leads o price change, herefore he price variabiliy-volume relaion arises. In chaper 4, we have repored a posiive relaion beween conemporaneous relaion beween rading volume and reurn, and we have explained ha i occurs as rading volume may conain he informaion of liquidiy risk as suggesed by Karpoff (1987) and Johnson (2007). As we have analysed above ha long erm mispricing persiss beween he Chinese ADRs and he underlying H shares may be due o he differen marke microsrucure of he wo markes which employ wo kinds of rading mechanisms and involve heerogeneous invesors, hese facors lead o price adjusing in differen process. Since he lieraure suggess ha rading volume is one imporan facor in conveying he price adjusmen process, we believe differen reurn volailiy-volume relaion beween he wo markes would give deeper insighs for he ADRs 155

156 mispricing. Therefore, a marke microsrucure perspecive o invesigae he volume-volailiy relaion would make an imporan conribuion o he lieraure of he ADRs arbirage. The relaionship beween rading volume and reurn volailiy has received considerable aenion in he finance lieraure. In erms of new informaion arriving ino he marke and is impac on he volume volailiy relaion, he wo exising hypoheses- he Mixure of Disribuions Hypohesis (MDH) and Sequenial Informaion Arrival Hypohesis (SIAH) make conrdicory predicions. On he one hand, he Mixure of Disribuions Hypohesis (MDH) originally proposed by Clark (1973) predics a posiive relaion beween conemporaneous sock reurn variance and rading volume. On he oher hand, he Sequenial Informaion Arrival Hypohesis (SIAH) proposed by Copeland (1976) and Jennings e al (1981) suggess a posiive bidirecional causal relaion beween changes in sock prices and rading volume. Prior empirical sudies on he volailiy-volume relaion found evidence on a conemporaneous as well as a lead-lag causaliy relaion beween volume and condiional reurn volailiy. Lamoureux and Lasrapes (1990), Anderson (1996), and Girard and Biswas (2007) found evidence in suppor of a conemporaneous volume volailiy relaion as prediced by he MDH for he US sock marke. Omran and McKenzie (2000) found similar evidence for he UK sock marke; Pyun e al (2000) for he Korean sock marke; and Bohl and Henke (2003) for he Polish sock marke. Wih regard o SIAH, alhough empirical evidence generally suppors causaliy beween rading volume and reurns volailiy, such evidence on he 156

157 direcion of causaliy is mixed. Gallan e al (1992), Gervais and Mingelgrin (2001), and Darra e al (2003, 2007) provide srong evidence for a posiive lead lag relaion beween volume and absolue price changes in he NYSE bu find he causaliy relaion only exiss from volume o reurn volailiy. On he conrary, Hiemsra and Jones (1994) and Brooks (1998) found he presence of bidirecional Granger causaliy beween daily sock reurns and changes rading volume in he US sock marke. Silvapulle and Choi (1999) find similar evidence from he Korean sock marke. As we can see from he lieraure, he majoriy of empirical researches on he volume-volailiy relaions cied above focus on single counry marke indexes and we know of no published empirical sudy on he volume-volailiy relaions of individual securiies raded in muliple markes. We examine he relaion beween daily informaion flow as measured by rading volume and he condiional volailiy of reurns of 15 individual Chinese ADRs lised on he NYSE and of heir corresponding primary lisings on Hong Kong sock markes (SEHK), he oal number of socks in our sample is 30. The primary objecive of our sudy is o compare and conras he volume-volailiy relaions of he Chinese ADRs and hose of heir underlying shares. We es if a conemporaneous correlaion exiss beween reurn volailiy and volume as prediced by MD hypohesis. We hen examine he lead lag relaions beween volume and volailiy using appropriae Granger-causaliy ess o es he predicions of he alernaive SIA hypoheses. We also es he compeing heories pu forh in he lieraure as explanaions for he presence of GARCH effecs in sock reurn volailiy. 157

158 In erms of modeling, we use a bivariae GARCH model in a VAR framework where reurn volailiies for ADRs and heir underlying securiies are joinly deermined by volume and volailiy in each marke. This chaper proceeds as follows: secion 5.2 gives he lieraure review on he wo hypoheses abou volume-volailiy relaionship; secion 5.3 inroduces he research mehodology and hypohesis developmen; secion 5.4 conains daa descripion and he empirical resuls; secion 5.5 is he conclusion Lieraure Review The Mixure Disribuion Hypohesis The Mixure Disribuion Hypohesis indicaes securiies reurn is no drawn from a single probabiliy disribuion bu from he join disribuion of volailiy and volume upon he rae of informaion arrival insead. The imporan papers include Clark (1973), Epps and Epps (1976), Tauchen and Pis (1983), Lamoureux and Lasrapes (1990), and Andersen (1996). Clark (1973) inended o model he sochasic process of he coon fuures price series and ried o explain why he probabiliy disribuion of he daily price change is lepokuric. The secondary finding of his paper is he variance of price change is a combinaion of price changes on individual rades, and a deficiency of volume a high price changes, caused by raders moving heir expecaions in unison. 158

159 Clark (1973) used his model 2 σ ν = Bν β o invesigae he curvilinear relaionship beween condiional price variance ( σ 2 ν ) and rading volume ( ν ) and found quie high correlaion beween hese wo variables by applying he model in he coon fuures marke. He explained ha in he coon fuures marke, if he informaion is asymmeric beween informed and uninformed raders, hen large price changes would be coinciden wih high volumes. Epps and Epps (1976) considered a wihin-day rading model o explain he price-formaion price where he changes in log price and ransacion volume are sochasic dependen. Their model is similar o Clark s (1973) and implied ha he condiional variance of he price change is a funcion of rading volume. Epps and Epps (1976) also repored empirical evidence by applying heir model o examine 20 NYSE-lised common socks based on he ransacion during he monh of January, , hey found posiive correlaion beween log( σ ) and log( ν 2 ). Tauchen and Pis (1983) derived a join probabiliy disribuion of he price change and he rading volume in heir empirical sudy of T-bill fuures marke. The model of Tauchen and Pis (1983) was differen wih he models of Clark (1973) and Epps and Epps (1976) in several ways, firs, boh Clark s model and Epps and Epps model required o specify in advance by nonlinear regression he funcional form of he condiional expecaion E( σ 2 V ) ; second, neiher of hese wo models considered growh in he size of speculaive markes as experienced by many of he new financial fuure markes. Therefore, Tauchen and Pis considered a seing wih J acive raders who ake long or shor posiion in a single fuures conrac, and he price adjus from ν 159

160 he (i-1) s o he i h wihin day Walrasian equilibrium. In heir model, rading volume is a funcion abou he absolue difference beween he change of Walrasian equilibrium price and he curren marke price, and he variance of he change of he curren marke price and he variance of rading volume include common variable which is relaed o J, he number of he marke raders. And finally, hey repored he covariance of he change of he marke price square and rading volume is greaer han 2 0, namely, Cov ( p, V ) > 0, where 2 p is he change of he marke price square, V is rading volume. Like Clark (1973) and Epps and Epps (1976), Tauchen and Pis (1983) examined he relaion beween log( p 2 ) and log( V ) by using OLS esimaion, hey found posiive relaion beween hese wo variables, a he same ime, hey repored ha he error erm of his regression funcion is heeroscedasicy. These findings suggesed he model of Auoregressive Condiional Heeroskedasiciy (ARCH) o be used in invesigaing he volailiy-volume relaion in he following sudies. Unlike Clark (1973), Epps and Epps (1976), and Tauchen and Pis (1983) who used he variance of he change of log price o capure he volailiy of reurn, Lamoureux and Lasrapes (1990) employed he Generalized Auoregressive Condiional Heeroskedasiciy (ARCH) o model he reurn volailiy. This paper sudied he relaion beween daily reurn volailiy and volume based on a sample of 20 acively raded common socks in he US sock marke wih he sample period of one year. Their empirical model was h = α 0 + α1ε 1 + α2h 1 + α3 V, where h is he GARCH erm from he fiing AR (n) model, and V is rading volume. Lamoureux 160

161 and Lasrapes (1990) found a significan relaion beween h andv, and a subsanial reducion in volailiy persisence when volume is included, which hey explained as he conemporaneous rading volume conaining he informaion abou he variance of he sock reurn. Andersen (1996) modified he MDH model ino a full dynamic represenaion by incorporaing a specific sochasic volailiy process for he informaion arrivals, unlike previous MDH approaches which applied an idenical join probabiliy disribuion of price changes and rading volume over each inerval, Andersen (1996) consiued a dynamic join disribuion of price changes and volume during each equilibrium phase. He described a dynamic marke specificaion in a microsrucure framework where hree disinc groups of raders, namely, specialiss, informed raders, and uninformed raders, kep revising heir price esimaions upon receiving eiher public or privae informaion over ime. Specifically, he daily reurn is condiionally normal wih variance which reflecs he inensiy of informaion arrivals, 2 namely, R K ~ N(0, σ K ) where R is daily reurn, K sands for he inensiy of informaion arrivals. V K ~ Po( m0 + IK µ ) is he specificaion of he dynamic rading volume, which is based on a Poisson approximaion incorporaing boh noise componen ( m 0 ) and informed componen ( IK µ ). Therefore, he covariance of he 2 reurn variance and rading volume is greaer han zero, namely, Cov ( R, V ) > 0. Andersen (1996) also repored empirical evidence of conemporaneous characerizaion of he reurn-volume relaion as suggesed by MDH based on a sample of 5 major common socks raded on he New York Sock Exchange in a ime 161

162 period of 18 years. Omaran and McKenzie (2000) followed he same mehodology as Lamoureux and Lasrapes (1990) and examined he common socks in he UK marke. Their sample included he daily reurns and volume on 50 Briish companies during he period from January 1988 o February The model hey esed was exacly he same as he model of Lamoureux and Lasrapes (1990) ha h = α 0 + α1ε 1 + α2h 1 + α3 V, and heir findings were consisen wih ha of Lamoureux and Lasrapes (1990) ha he coefficien of volume was highly significan for all companies and volailiy persisence became negligible for mos socks when rading volume was involved. However, conradicing Lamoureux and Lasrapes (1990); hey argued ha GARCH effecs canno be explained by he serial dependence in volume of rade, because he srucure of he model iself ha h 1 is iself a funcion of V 1. Moreover, V is highly correlaed wih is pas, V 1; V 2 ; ; which can lead o a mulicollineariy problem beween he explanaory variables used, h 1 and V 1. Similar empirical evidence also include Pyun, Lee, and Nam (2000) and Bohl and Henke (2003). Boh of hese wo papers followed he approach of Lamoureux and Lasrapes (1990) and repored consisen resuls wih Lamoureux and Lasrapes (1990). Pyun, Lee, and Nam (2000) sudied weekly reurns of socks lised on he Korean Sock Exchange during he 5 year period beween 1990 and Bohl and Henke (2003) consider daily reurns and he rading volume for 20 socks lised a he Warsaw Sock Exchange (WSE) over he period from January, 1999 o Ocober,

163 5.2.2 The Sequenial Informaion Arrival Hypohesis The conradicory heory o MDH is he Sequenial Informaion Arrival Hypohesis (SIAH) of Copeland (1976), Jennings, Sarks and Fellingham (1981), Gallan, Rossi and Tauchen (1992), Hiemsra and Jones (1994), Gervais and Mingelgrin (2001), and Darra, Rahman and Zhong (2003). The main difference beween he SIAH and he MDH is ha he MDH assumes all raders have homogeneous response o new informaion, while he SIAH assumes new informaion is disseminaed sequenially o raders and in a random order, and raders responds o he new informaion heerogeneously. The raders adjus heir posiions and expeced marke price based on he observed marke price and heir own privae informaion. As such, before a final equilibrium is aained, a series of sequenial equilibriums as inermediaes conain informaion on pas volailiy daa ha can be used o forecas rading volume, or vice versa. Due o he lagged sequenial informaion flow absolue sock reurns could have predicive power for curren rading volume and vice versa, which imply bidirecional causaliy beween volume and volailiy. Copeland (1976) developed a heoreical model o describe a seing where N raders possessed an idenical se of informaion, bu each of hem would shif heir demand curve in differen magniude and direcion. Furher, he considered hree cases wih shor sale binding, namely, all raders were pessimisic, all raders were opimisic, and raders were mixure of pessimisic and opimisic. His model had 163

164 some sric assumpions such as he percenage of opimisic raders was symmerically disribued wih he mean of 0.5, and he shor sale consrain was binding ha he uninformed raders would no sell more han hey have. Since all raders would shif heir demand curve differenly, Copeland developed sequenial equaions of equilibrium price and he corresponding volume a differen sages beween he original and he final equilibria. Upon hese assumpions, he model prediced a posiive correlaion beween absolue price change and rading volume a sequenial equilibrium. Jennings, Sarks and Fellingham (1981) specified a paricular dynamic price adjusmen process ha i assumed ha only one rader observed he informaion iniially. This rader inerpreed he news, revised his beliefs, and raded o arrive a a new opimal posiion. The nex invesor became informed based on his new equilibrium, and afer a similar sequence of evens, a second emporary equilibrium was achieved. This process coninued unil all raders were informed and resuls in a series of momenary equilibria. When he las rader receives he informaion, he marke reaches a final equilibrium. The oucome of his series of evens was he generaion of a sequence of ransacion volume. Jennings e al (1981) modified he model of Copeland (1976) by considering informed and uninformed raders and a margin requiremen as a realisic resricion on shor sales. Their model also heoreically prediced a posiive correlaion beween he absolue price change and rading volume. Gallan, Rossi and Tauchen (1992) underook an empirical invesigaion of he 164

165 dynamic inerrelaionships among price and volume movemens of he US sock marke index. Their sample was composed of he daily closing value of he S&P composie sock index and he daily volume of shares raded on he NYSE wih he ime period from 1928 o Their resuls suggesed ha large price changes lead o increases in boh he mean and variabiliy of he volume. Gervais and Mingelgrin (2001) invesigaed he high-volume reurn premium. The high-volume reurn premium is such kind of volume-reurn relaionship ha periods of high rading volume end o be followed by periods of posiive excess reurns, whereas periods of low volume end o be followed by negaive excess reurns. Their findings also confirmed ha a posiive relaion exiss beween he average cumulaive reurns and rading volume, and ha he shocks in he volume conain informaion abou fuure reurns. Hiemsra and Jones (1994) empirically sudied boh linear and non-linear causaliy relaion beween volume and reurn. Their sample included daily reurn and rading volume daa of Dow Jones sock index for he ime period from 1915 o They employed boh radiional linear Granger causaliy es and he modified Baek and Brock es which is a non-parameric Granger causaliy es. The radiional linear Granger causaliy es deeced unidirecional Granger causaliy from sock reurns o rading volume. In conras, he modified Baek and Brock es provides evidence of significan nonlinear bidirecional Granger causaliy beween sock reurns and rading volume. Silvapulle and Choi (1999) used daily Korean Composie Sock Index daa o 165

166 sudy he linear and non-linear Granger causaliy beween sock price and rading volume. They followed he modified Baek and Brock es by Hiemsra and Jones (1994) and repored significan bidirecional causaliy beween rading volume and he reurn volailiy prediced by he GARCH (1, 1) model. Darra, Rahman and Zhong (2003) examined he conemporaneous correlaion as well as he lead lag relaion beween rading volume and reurn volailiy. Their sample consised of all socks comprising he Dow Jones indusrial average (DJIA) from April 1, 1998 o June 30, They used 5-minue inraday daa and measure reurn volailiy by he exponenial generalized auoregressive condiional heeroscedasiciy mehod (EGARCH). They applied Granger causaliy es o sudy boh conemporaneous and lead-lag relaion on a bivariae vecor auoregression model (VAR). Their findings srongly suppored he SIAH bu found lile evidence of MDH Research mehodology and hypohesis developmen Model selecion for reurn volailiy The variance of he price change was he proxy o sand for reurn volailiy in he earlier lieraure of volume-volailiy relaion, such as Clark (1973), Epps and Epps (1976), and Tauchen and Pis (1983). However, hese papers all repored ha he error erm of he OLS esimaed regression funcion of log( p 2 ) on log( V ) is 166

167 heeroscedasicy. Since Engle published his remarkable paper abou Auoregressive Condiional Heeroskedasiciy (ARCH) model in 1982, Lamoureux and Lasrapes (1990) urned o use he Generalized Auoregressive Condiional Heeroskedasiciy (GARCH) o model he reurn volailiy. Thereafer, GARCH model became widely used in he sudy of reurn volailiy-volume relaion. Furher, Kim and Kon (1994) compared hree models: GARCH, Exponenial GARCH (EGARCH), and Threshold GARCH (TGARCH), hey found ha boh EGARCH and TGARCH models could capure he condiional heeroscedasiciy and he asymmeric leverage effec of he reurn series fairly well, in addiion, he individual sock s reurn is in favor of TGARCH model, while he EGARCH model is more likely a proper descripion for he sock index reurn. In his chaper, we will examine he heeroscedasiciy of reurn series by applying Ljung-Box es. And hen follow he approach of Kim and Kon (1994) and Giraid and Biswas (2007), who used wo asymmeric GARCH mehods, namely, he Threshold GARCH and Exponenial GARCH, o model sock reurn volailiy. These wo models capure asymmeric characerisics of he posiive/negaive shock (namely good/bad news). Paricularly, Threshold GARCH model is able o involve posiive shock where he error is above he hreshold value of zero, and negaive shock where he error is below he hreshold value of zero. Generally, negaive shocks have a greaer effec on condiional volailiy han posiive shocks of he same magniude, which is known as leverage effec ha volailiy clusering in asymmeric paern. The reason we apply hese wo asymmeric GARCH models is because leverage 167

168 effec is commonly observed in equiy markes ha volailiy is higher in a falling marke han i is in a rising marke. The volailiy response o a large negaive reurn is ofen far greaer han i is o a large posiive reurn of he same magniude. Apar from leverage effec, he Threshold GARCH and Exponenial GARCH models also accoun for wo oher characerisics. The firs is volailiy clusering which implies large (small) price changes end o follow large (small) price changes. The second characerisic is fa ail which is characerized as lepokurosis and skewness, and boh of which indicae deparure from normaliy of he daa, and boh of which are regarded as he paricular feaure of daily sock reurns. Furher, hese wo models allow for a general probabiliy densiy funcion (i.e., generalized error disribuion, GED), which ness he normal disribuion along wih several oher possible densiies. Bollerslev e al. (1992) noed ha imposing he normaliy assumpion on he GARCH model could bias he esimaes. Finally, many GARCH models have o place non-negaive consrains on he parameers o avoid generaing negaive variances, even hough his may unduly resrain he model dynamics. The EGARCH model eliminaes he need for such consrains by formulaing he condiional variance in logarihmic erms. Alhough Kim and Kon (1994) argued individual sock s reurn is fond of TGARCH raher han EGARCH, Girard and Biswas (2007) showed here was no preferred one beween he TGARCH and EGARCH models. Following Girard and Biswas (2007), we will use boh TGARCH and EGARCH model o esimae reurn volailiy process. We give our mean reurn equaion and reurn volailiy equaion 168

169 according o TGARCH model as: p R = α + r= 0 R + ε (1) βr 1 2 σ =α + ψ 2 1 ε + 2 γε d 1 + λσ (2) Where R is he realized reurn of he sock, expressed as an AR (p) process wih an error erm of mean zero and condiional varianceσ 2. Lags p in AR process is seleced based on AIC and SBC crieria. The condiional variance 2 σ is specified as a funcion of he mean volailiyα, ε which is he lag of he squared residual from 2 1 he mean equaion (he ARCH erm) and which provides news abou volailiy clusering; σ 2 1 which is he las period s forecas variance (he GARCH erm) and finally, he erm for capuring he asymmery ε 2 1 d 1. The parameer d is a dummy which equals 1 if ε <0, and 0 oherwise, so ha good news ( ε >0) and bad news ( ε <0) are allowed o have differen effecs on he condiional variance. Good news has an effec ofψ, while bad news has an effec of ψ +γ. Accordingly, if γ >0, a leverage effec, exiss, hen bad news has greaer effec han good news. The EGARCH model has he same mean equaion as he one of TGARCH model, bu is differen in he condiional variance equaion which is defined in erms of a sandard normal variae z : lnσ 2 = ω + g(z -1 ) + β lnσ 2 1 (3) Where g(. ) is an asymmeric response funcion defined by g(z ) = λ z + ϕ( z 2/ π ), where ( z 2 / π ) is he mean deviaion of z since 2 / π = E( z ) EGARCH is difficul o use for volailiy forecasing because here is no analyic form for he 169

170 5.3.2 De-rend Trading volume Previous papers have repored ha rading volume is no saionary and wih rend, since we will use vecor auoregression (VAR) framework o es Granger causaliy of volume-volailiy relaion as suggesed by SIAH, i requires he variables in he VAR framework are saionary. Following Lee and Rui (2002) and Girard and Biswas (2007), we de-rend he rading volume series by assuming volume as a deerminisic funcion of ime. As repored by Gallan e al (1992), rading volume series is composed of boh linear and nonlinear ime rend, we include boh ime and quadraic ime rend erms: Vol = + + χ 2 + (4) Where Vol represens raw daily rading volume and is ime. For he 15 Chinese ADRs and heir underlying shares, he coefficiens for boh linear and non-linear rend erm are significanly differen from zero. In he following analysis we will employ rading volume wihou rend for he 15 Chinese ADRs and heir underlying HK shares. The de-rended rading volumes as unobservable informaion arrival are he residuals from equaion (4) Tes MDH volailiy erm srucure. 170

171 Lamoureux and Lasrapes (1990) developed a mehod o empirically examine he MDH by incorporaing rading volume ino equaion (2), and hey argue ha if rading volume and reurn volailiy are joinly disribued, hen persisence of volailiy should become negligible when rading volume is incorporaed, and here is a posiive relaion beween reurn volailiy and rading volume. However, Lamoureux and Lasrapes (1990) suggesed volume may be endogenous o he sysem and would cause ha simulaneiy bias, so Girard and Biswas (2007) alernaively employed volume wih one lag in he variance equaion, we follow Girard and Biswas (2007) o es he MDH model as below: 2 σ =α + ψ 2 1 ε + γε d + λσ + δ V 1 (5) 2 1 Where he oher erms are same as ha in equaion (2), V 1 sands for he conemporaneous rading volume afer de-rended. According o he MDH, persisence of volailiy is measured by ( ψ + γ + λ ), if ( ψ + γ + λ ) equals one, hen curren shocks persis indefiniely in condiioning he fuure variance. I also represens he change in he response funcion of shocks o volailiy per period. And if ( ψ + γ + λ ) is greaer han one, which implies ha he response funcion of volailiy is explosive. Likewise, if ( ψ + γ + λ ) is less han one, which implies ha he response o volailiy shocks declines over ime. As demonsraed in Lamoureux and Lasrapes (1990) and Girard and Biswas (2007) ha when conemporaneous rading volume is involved, persisence of volailiy would disappear, so our null hypohesis is V is no posiively correlaed wihσ 2, and ( ψ + γ + λ ) will be significanly differen 1 from zero. 171

172 5.3.4 Tes SIAH The SIAH has been esed by applying Granger causaliy es, for example, Hiemsra and Jones (1994), Silvapulle and Choi (1999), and Darra, Rahman, and Zhong (2003). We follow hese papers o examine he lead-lag relaions beween volume and volailiy by using Granger causaliy es. Granger causaliy means ha a lead-lag relaionship is eviden beween variables in a mulivariae ime series, or one variable happens before and helps o predic anoher one. According o he SIAH, due o he sequenial informaion flow, lagged rading volume could have predicive power for curren absolue sock reurns and lagged absolue sock reurns could have predicive power for curren rading volume. We give he esing model as below: 2 σ = α 1 + V = α 2 + p 2 kσ k k = 1 q β + θ k + ε 1 (5) m 2 kσ k k = 1 k = 1 n k V δ + φ kv k + ε 2 (6) k = 1 Where 2 σ is he reurn volailiy and V is he de-rended rading volume. In equaion (5), if he θ k coefficiens are saisically significan, hen inclusion of he pas rading volume, in addiion o he pas volailiy, yields a beer forecas for he fuure volailiy, and we say volume cause reurn. Likewise, in equaion (6), if reurn volailiy cause volume, he coefficien of δ k will be significanly differen from zero. We use a Granger causaliy Wald es o es ha δ 1 = δ 2 = = δ m = 0 and θ 1 = θ 2 = = θ q = 0. Because when we have a large sample, he Wald es can have a 172

173 beer approximae, we do no use Granger causaliy F es is because F es emphasizes ha he errors are normally disribued and he explanaory variables are reaed as non-sochasic (Griffihs, Hill, and Judge, 1993: 456) Daa and empirical resuls Daa We use he same daa sample as for he sample in chaper 4, which consiss of daily prices (see he descripive saisics in Table 4.3) and rading volumes (see he descripive saisics in Table 4.11) on he Chinese ADRs lised on he US sock exchanges and heir corresponding underlying securiies lised on he Sock Exchange of Hong Kong (SEHK). We compue coninuously compounded reurns on he underlying socks lised a SEHK (Hong Kong Sock Exchange) and heir corresponding i i i ADR lisings in NYSE as r = ln( P / P 1) where i P denoes closing price of securiy i on day Resuls of model selecion for reurn volailiy So in he following, we analyze he heeroscedasiciy of reurn series. In saisics, a sequence or a vecor of random variables is heeroscedasic if he random variables have ime-varying variances. Heeroskedasiciy does no cause OLS coefficien esimaes o be biased. However, he variance (he sandard errors) of he coefficiens 173

174 ends o be underesimaed, increasing he -raio and is probably o make insignifican variables appear o be saisically significan. Many financial reurn series display volailiy clusering, ha is auoregressive condiional heeroscedasiciy, and which implies a srong auocorrelaion in squared reurns, so we uilize Ljung-Box es o examine if reurn and squared reurn series are serial correlaed, an auocorrelaed ime series means he covariance is no independen of ime. The Ljung-Box Q saisic is calculaed based on he sample auocorrelaion, under he null hypohesis of zero auocorrelaion, Q will have an asympoic 2 χ disribuion wih cerain degree of freedom, he Ljung-Box Q(6) and Q(12) saisics for reurn and squared reurn auocorrelaions are repored in Table 5.1. Table5.1. The Ljung-Box Q saisics (Q(6) and Q (12) are Ljung-Box saisics for reurns disribued as 2 χ wih 6 and 12 degrees of freedom respecively, Q 2 (6) and Q 2 (12) Ljung-Box saisics for squared reurns disribued as 2 χ wih 6 and 12 degrees of freedom respecively.) Symbol Marke Q(6) Q(12) Q 2 (6) Q 2 (12) ACH NYSE 12.99** *** 49.60*** SEHK 11.54** 20.19* 24.46*** 78.80*** CBA NYSE *** 29.22*** SEHK *** *** LFC NYSE *** *** SEHK *** 95.75*** CHL NYSE *** *** SEHK 21.94*** 31.60*** *** *** CHA NYSE *** *** SEHK *** 83.56*** CEO NYSE *** 43.90*** SEHK *** 66.12*** GSH NYSE 23.98*** 36.22*** *** *** SEHK *** *** PTR NYSE *** *** 174

175 SEHK 13.41** *** *** CHU NYSE *** 38.57*** SEHK *** 67.07*** CEA NYSE *** *** SEHK *** 98.77*** *** SNP NYSE ** *** *** SEHK 15.87*** 18.69* 58.43*** *** ZNH NYSE *** *** SEHK *** *** HNP NYSE 8.81*** *** *** SEHK 18.51*** 21.30** 67.00*** *** SHI NYSE *** *** SEHK *** *** YZC NYSE *** 41.68*** SEHK *** *** Noe:*** indicaes a less han 1% significan level, ** indicaes a less han 5% significan level, * indicaes a less han 10% significan level Daa presened in Table 5.1 indicaes ha only 1 ou of 15 ADRs have significan auocorrelaion in boh 6 and 12 orders; 4 ou of 15 HK shares have significan auocorrelaion in boh 6 and 12 orders. While he significan Ljung-Box es saisics Q 2 (6) and Q 2 (12) indicae he presence of condiional heeroscedasiciy for all ADRs and heir underlying shares. These findings jusify he use of GARCH modeling (Bollerslev, 1986), which allows for condiional variance in he reurns. Nex, following Kim and Kon (1994) and Giraid and Biswas (2007), we use TGARCH o model reurn volailiy and examine he leverage effec ; we repor he coefficiens of he good news and bad news respecively. We also apply EGARCH as comparison wih he TGARCH model, and provide likelihood raios of boh models in Table

176 Table 5.2. Volailiy persisence wihou volume Symbol Marke 2 ε 1 d 2 ε σ 1 LL1 LL2 ACH NYSE 0.058(12.13)*** 0.003(0.39) 0.581(27.20)*** SEHK 0.071(18.74)*** (-0.50) 0.558(29.36)*** CBA NYSE 0.147(51.33)*** 0.002(0.51) 0.421(39.75)*** SEHK 0.103(57.01)*** (-7.68)*** 0.383(32.97)*** LFC NYSE 0.133(13.97)*** 0.057(4.38)*** 0.494(21.05)*** SEHK 0.046(9.90)*** 0.019(2.82)*** 0.530(19.70)*** CHL NYSE 0.091(25.11)*** (-0.87) 0.537(37.66)*** SEHK 0.254(67.60)*** (0.10) 0.423(48.88)*** CHA NYSE 0.121(22.70)*** 0.036(5.11)*** 0.536(31.39)*** SEHK 0.083(13.67)*** 0.014(1.75)* 0.506(22.20)*** CEO NYSE 0.076(36.45)*** (-0.06) 0.472(28.47)*** SEHK 0.069(18.77)*** 0.043(8.22)*** 0.329(14.00)*** GSH NYSE 0.288(78.80)*** 0.073(11.45)*** 0.352(45.00)*** SEHK 0.203(45.92)*** (-1.52) 0.463(45.20)*** PTR NYSE 0.139(38.04)*** 0.019(3.81)*** 0.424(32.13)*** SEHK 0.113(22.39)*** 0.048(6.78)*** 0.400(23.81)*** CHU NYSE 0.024(6.49)*** (1.66) 0.470(21.61)*** SEHK 0.106(51.75)*** (-8.41)*** 0.307(23.96)*** CEA NYSE 0.220(82.14)*** (-2.27)** 0.456(56.69)*** SEHK 0.314(53.66)*** 0.001(0.22) 0.453(49.39)*** SNP NYSE 0.050(26.64)*** (-10.93)*** 0.491(26.73)*** SEHK 0.009(40.76)*** (-50.82)*** 0.355(25.18)*** ZNH NYSE 0.10(20.29)*** 0.111(16.91)*** 0.627(56.12)*** SEHK 0.156(56.22)*** (-2.62)*** 0.446(46.06)*** HNP NYSE 0.200(45.53)*** 0.041(6.56)*** 0.415(38.26)*** SEHK 0.196(45.96)*** 0.020(2.95)*** 0.406(32.77)*** SHI NYSE 0.176(53.94)*** 0.001(0.19) 0.545(58.46)*** SEHK 0.029(40.93)*** (-44.73)*** 0.523(46.56)*** YZC NYSE 0.271(47.91)*** 0.026(4.14)*** 0.607(88.71)*** SEHK 0.063(18.92)*** (-13.56)*** 0.412(22.47)*** Mean NYSE SEHK Maximum NYSE SEHK Minimum NYSE SEHK Significan NYSE SEHK Sig. and NYSE

177 Posiive SEHK Noe:*** indicaes a less han 1% significan level, ** indicaes a less han 5% significan level, * indicaes a less han 10% significan level In able 5.2, we repor LL1 which is he maximum log likelihood aained wih he above TGARCH model, and LL2 which is he maximum log likelihood ha would have been obained if EGARCH was uilized. ε and ε 1 1 d sand for good news and bad news respecively. 2 σ 1 measures he GARCH effec wih one-period lag. The coefficiens are esimaed based on equaion (1) and (2), he lags of R is chosen based on SBC and AIC. p R = α + r= 0 R + ε (1) βr 1 2 σ =α + ψ 2 1 ε + 2 γε d 1 + λσ (2) These resuls indicae he following: a) All Chinese ADRs and heir underlying 2 HK shares have significan coefficien of good news ( ε 1 ). The coefficiens of ε 2 1 range from (CHU) o (GSH) for ADRs, while range from (SNP) o (CEA) for HK shares. b) Wih regard o reflecion on bad news, he ADRs on he NYSE have differen paern wih he underlying shares on he SEHK, he average coefficien is posiive for ADRs whereas negaive for HK shares, and he number of significan and posiive coefficien of ADRs is more han ha of he HK shares. Which suggess he invesors in he wo sock markes differ in he senimen o bad news. On he NYSE he leverage effec of bad news is much bigger han he invesors on he SEHK, 177

178 which imply he US invesors are more senimenal o bad news. This finding is ineresing, and we find supporive evidence from recen published paper. Arquee e al (2008) compared he price of he Chinese socks lised in Shanghai wih he price of he same firms bu lised in Hong Kong and he US. They found he price differenial is significanly deermined by he invesors senimen which is capured as he company P/E raio in each marke. On he oher hand, in chaper 4, we es he comovemen effec on he Chinese ADRs mispricing, we find he US invesors over reac o he US sock marke index ha is also demonsraed by Kim e al (2000). These findings may be he eviden of invesors senimen hypohesis ha sock price is a funcion of invesors senimen and he US invesors are more pessimisic han he oher. Furher, he differen reflecions wih bad news in he US and HK marke jusifies he earlier conclusion in chaper 4 ha he inequaliy disribuion of he reurns of he Chinese ADRs and heir underlying HK shares. c) The persisence of condiional volailiy of he ADRs on he NYSE is higher han ha of he HK shares on he SEHK; and we also find similar evidence from he published paper. Xu and Fung (2002) sudied price discovery and volailiy spillover effec of he Chinese ADRs. Using he bivariae GARCH model, hey found he coefficiens of he ADRs reurn volailiy are higher han ha of he H shares reurn volailiy. So hey concluded ha he Chinese ADRs lised on he NYSE play a bigger role in volailiy spillover. However, we also find none of he pas volailiy coefficien ( ψ + γ + λ ) is 178

179 close o one for he ADRs and H shares, which implies ha he response o volailiy shocks declines quickly over ime. d) As consisen wih he findings of Girard and Biswas (2007), we also find sligh higher value of likelihood raio of TGARCH (1, 1) han ha of EGARCH (1, 1) for mos of he Chinese ADRs. However he likelihood raios for TGARCH and EGARCH are very close, so we do no carry ou he likelihood raio es Resuls of he es on he MDH Nex, we proceed o es he MDH, we repor resuls in able 5.3. Table 5.3. Conemporaneous volume-volailiy relaion es wih rading volume. Symbol Marke 2 ε 1 d 2 ε 1 1 V 2 σ 1 1 LL1 LL2 (imes 10 4 ) ACH NYSE 0.058(11.98)*** (0.35) 0.578(26.83)*** 0.1(1.28) SEHK 0.07(17.72)*** (-0.46) 0.552(28.73)*** 0.1(0.99) CBA NYSE 0.148(50.47)*** 0.001(0.33) 0.425(39.70)*** -0.3(-2.61)*** SEHK 0.103(56.16)*** (-7.70)*** 0.383(32.94)*** (-0.62) LFC NYSE 0.128(12.36)*** 0.057(4.36)*** 0.481(19.00)*** 0.3(1.37) SEHK 0.040(8.16)*** 0.019(2.87)*** 0.509(18.63)*** 0.4(3.51)*** CHL NYSE 0.091(24.96)*** (-0.85) 0.537(37.66)*** (-0.54) SEHK 0.254(66.58)*** (0.10) 0.423(48.62)*** -0.2(-1.10) CHA NYSE 0.122(21.65)*** 0.036(5.07)*** 0.538(31.06)*** (-0.77) SEHK 0.082(13.03)*** 0.014(1.78)* 0.505(22.08)*** (0.59) CEO NYSE 0.076(35.95)*** (0.01) 0.475(28.59)*** (-1.97)** SEHK 0.067(17.65)*** 0.043(8.31)*** 0.325(13.90)*** 0.2(2.84)*** GSH NYSE 0.289(78.43)*** 0.073(11.58)*** 0.355(45.09)*** -0.4(-2.90)*** SEHK 0.204(45.30)*** (-1.58) 0.464(44.92)*** -0.1(-0.78) PTR NYSE 0.139(37.61)*** 0.019(3.81)*** 0.423(31.93)*** (1.18) SEHK 0.110(20.86)*** 0.048(6.81)*** 0.394(23.10)*** 0.3(2.36)*** CHU NYSE 0.021(5.81)*** (1.63) 0.463(21.20)*** 0.2(1.44)

180 SEHK 0.106(48.93)*** (-8.41)*** 0.307(23.35)*** -0.03(-0.30) CEA NYSE 0.223(80.09)*** (-2.32)** 0.463(56.34)*** -0.4(-3.78)*** SEHK 0.317(52.60)*** (-0.14) 0.454(49.39)*** -0.8(-2.09)*** SNP NYSE 0.050(26.46)*** (-10.91)*** 0.489(26.60)*** 0.039(0.96) SEHK 0.009(39.70)*** (-49.28)*** 0.355(24.80)*** (0.39) ZNH NYSE 0.10(20.29)*** 0.111(16.91)*** 0.627(56.12)*** 0.3(1.23) SEHK 0.156(56.22)*** (-2.62)*** 0.446(46.06)*** -0.3(-1.75)* HNP NYSE 0.199(43.42)*** 0.041(6.58)*** 0.413(37.30)*** 0.2(1.06) SEHK 0.196(45.94)*** 0.019(2.88)*** 0.404(32.23)*** -0.1(-0.95) SHI NYSE 0.176(52.62)*** 0.001(0.19) 0.545(57.65)*** (-0.22) SEHK 0.029(40.41)*** (-44.34)*** 0.528(46.91)*** -0.1(-4.35)*** YZC NYSE 0.271(47.73)*** 0.025(4.05)*** 0.607(88.72)*** -0.2(-1.06) SEHK 0.062(18.34)*** (-13.15)*** 0.410(22.37)*** 0.5(1.48) Mean NYSE SEHK Maximum NYSE SEHK Minimum NYSE SEHK Significan NYSE SEHK Sig. and NYSE Posiive SEHK Noe:*** indicaes a less han 1% significan level, ** indicaes a less han 5% significan level, * indicaes a less han 10% significan level In able 5.3, we repor LL1 as he maximum log likelihood aained wih he above TGARCH model, and LL2 as he maximum log likelihood ha would have been obained if EGARCH was uilized. ε and ε 1 1 d sand for good news and bad news respecively. 2 σ 1 measures he GARCH effec wih one-period lag. 1 V measures he conemporaneous volume. The esing model is: 2 σ =α + ψ 2 1 ε + 2 γε d + λσ 1 + V 1 In Table 5.3, we include de-rended rading volume wih one lag o es he conemporaneous volume-volailiy relaion as suggesed by MDH. The coefficiens 180

181 of pas surprises and innovaions only change slighly as compared wih he resuls wihou conemporaneous rading volume, and we do no find posiive and significan correlaion beween volailiy and volume for all ADRs on he NYSE, hough we find 3 posiive and significan correlaions beween volailiy and volume ou of 15 underlying shares on he SEHK. Furher, he persisence of volailiy do no become negligible afer involving rading volume, his is also conradic o he predicion of he MDH. So our finding does no suppor MDH. On he oher hand, we do no find significan reducion of volailiy persisence when he conemporaneous volume series is incorporaed, hough his evidence is inconsisen wih he findings of Lamoureux and Lasrapes (1990), we also find compaible evidence of he findings of Lee and Rui (2002) and Bessembinder and Seguin (1993) Resuls of he es on he SIAH Finally, we repor he resuls of he es on he SIAH in able 5.4. We consruc VAR model, as presened in equaions (5) and (6) o examine he lead-lag relaions beween volume and volailiy by using Granger causaliy es, and allow lags up o 5, which is one week lengh. 181

182 Table 5.4. Granger causaliy beween volume and volailiy. Symbol Marke H 0: V 2 2 σ H 0: σ V ACH NYSE 2.5e+08(0.000)*** (0.353) SEHK (0.000)*** (0.667) CBA NYSE (0.000)*** (0.530) SEHK (0.000)*** (0.010)*** LFC NYSE (0.000)*** (0.422) SEHK 30.73(0.000)*** (0.666) CHL NYSE (0.000)*** (0.486) SEHK (0.000)*** 3.843(0.279) CHA NYSE (0.000)*** (0.727) SEHK (0.000)*** (0.916) CEO NYSE (0.000)*** (0.064)* SEHK 24.56(0.000)*** (0.284) GSH NYSE 32.43(0.000)*** (0.187) SEHK 46.73(0.000)*** 4.47(0.215) PTR NYSE (0.000)*** (0.063)* SEHK (0.000)*** (0.512) CHU NYSE (0.000)*** (0.057)* SEHK (0.000)*** (0.449) CEA NYSE (0.000)*** (0.877) SEHK (0.000)*** 1.244(0.742) SNP NYSE (0.083)* (0.482) SEHK (0.000)*** 2.429(0.488) ZNH NYSE (0.022)** (0.927) SEHK (0.021)** (0.060)* HNP NYSE (0.003)*** (0.498) SEHK (0.002)*** (0.452) SHI NYSE (0.000)*** (0.214) SEHK (0.000)*** (0.533) YZC NYSE (0.002)*** (0.468) SEHK (0.000)*** (0.795) Significan NYSE 15 4 SEHK 15 2 Noe:*** indicaes a less han 1% significan level, ** indicaes a less han 5% significan level, * indicaes a less han 10% significan level The esing models are: 182

183 2 σ = α 1 + V = α 2 + p 2 kσ k k = 1 q β + θ k + ε (5) m 2 kσ k k = 1 k = 1 n k V δ + φ kv k + ε 2 (6) k = 1 1 The null hypohesis is (1) volume does no cause reurn volailiy, so θk joinly equals o zero; (2) reurn volailiy does no cause volume, so δ k joinly equals o zero. Granger causaliy Wald ess are used, and χ 2 saisics wih p-value in parenhesis are repored in able 5.4. Table 5.4 conains resuls of he se of equaions 5 and 6, Granger causaliy is esimaed using he Wald. We find significan causaliy relaion from rading volume o volailiy in 15 ADRs and underlying shares in boh markes, and find significan causaliy relaion from volailiy o rading volume in 4 ADRs and 2 underlying shares. This finding is in suppor of he SIAH and corroboraes Darra, Rahman, and Zhong (2003). 5.5 Conclusions In his paper, we use daily reurn volailiy and de-rended rading volume in TGARCH and EGARCH process o incorporae persisence in reurn volailiy. We examine he conemporaneous versus lead lag relaions beween volume and volailiy in 15 Chinese ADRs on he NYSE and heir underlying shares on he SEHK. Our main findings are: firs, here are differen paerns in leverage effec on bad news beween wo markes, as well as various magniude of volailiy persisence 183

184 over ime beween he wo markes. This may give supporive evidence o our findings in chaper 4 ha he Chinese ADRs and he H shares have differen reurn disribuions. Second, we find lile evidence in suppor of MDH. The conemporaneous correlaions are posiive and saisically significan in only 3 of he 15 underlying shares on he SEHK. And all ADRs and remaining 12 underlying shares do no exhibi significan and posiive correlaion beween volume and reurn volailiy. Such weak evidence of conemporaneous correlaions conradics he predicion of he MDH. Third, we find supporive evidence for he SIAH. The rading volume and reurn volailiy are found o follow a clear lead lag paern in all ADRs and heir underlying shares. Bu mos of evidence suggess a Granger causaliy relaion from rading volume o reurn volailiy, hough his is consisen wih Darra, Rahman, and Zhong (2003), we suspec he modified Baek and Brock es as developed by Hiemsra and Jones (1994) could make a deeper examinaion on he bidirecional relaion beween volume and volailiy. However, due o he limi of ime and difficul mahemaical requiremens, we have o leave i as fuure sudy. 184

185 Chaper 6 Conclusion This hesis is o explore he issue of he arbirage of he cross-lised securiies by looking ino a paricular seing, he Chinese ADRs. This sudy is especially ineresed in invesigaing he securiies rading behavior from he marke microsrucure perspecive. The new hings have been discovered as resul of our research and added o he knowledge: 1. Differences in reurn disribuion beween he ADRs and heir underlying shares can creae arbirage possibiliy; 2. Price differenials of he ADRs could be caused no only by conemporaneous bu also lagged comovemen effec; 3. Firms ownership srucure could be one of he facors o affec price differenials beween he ADRs and heir underlying shares; 4. Differen liquidiy risk and illiquidiy cos are he facors deermining he ADRs price differenials; 5. Differences in he invesors senimen wih bad news cause differen volailiy beween he ADRs and heir underlying shares. Firs, we have demonsraed ha for he cross-lised securiies, differences in reurn disribuion beween he ADRs and heir underlying shares may creae arbirage possibiliy. Earlier sudies such as Kao e al. (1991), Miller and Morey (1996), and Karolyi and Sulz (1996) concluded ha ADRs do no presen invesors wih any arbirage opporuniies. These papers employed he approaches which only examine he locaions, such as mean and median of he securiies reurn daa. However, we are paricularly ineresed in reurn disribuions because recenly developed approach, for example, he Copula weighed porfolio which is based on he higher momen 185

186 dependence beween markes, has been widely used in inernaional financial insiuions o exploi arbirage profi across muliple markes. Therefore, we adoped a se of mehods o compare boh locaion and shape of wo securiies reurn. By employing he approach of Kao e al (1991), we compared he mean and median of he Chinese ADRs and heir underlying H shares reurn, we could no rejec he equaliy of wo securiies reurn as Kao e al repored in heir paper. On he oher hand, by employing he approach of Rabinovich e al (2003) o compare reurn disribuion, we found wo securiies reurn disribuions are differen for mos of he Chinese ADRs. This finding reinforces he sudy of he ADRs arbirage ha difference in higher momens of securiies reurn may creae arbirage possibiliy. Second, we have demonsraed ha price differenials beween he Chinese ADRs and heir underlying H shares are caused no only by conemporaneous bu also lagged comovemen effec, and he comovemen effec wih he US marke dominaes he effec wih Hong Kong. We firs used wo correlaion ess as Kao e al (1991) o examine pair-wise correlaion beween wo securiies reurns. Our finding of he correlaion ess are similar o Kao e al (1991) ha showed ha he reurns of he ADRs and he underlying socks are significanly correlaed, bu hese correlaion coefficiens are no close o one, and hey suggesed he non-overlapping rading hour is one of he possible reasons. We hen followed he approach of Gagnon and Karolyi (2004) o specify he impacs of he US and Hong Kong marke reurns on each individual securiies. Our findings are consisen wih Gagnon and Karolyi (2004) who repored he significan conemporaneous comovemen effec. A he same ime, 186

187 we conribue o he lieraure ha we also revealed significan lagged comovemen effec beween marke index and he ADRs price differenials. Especially, wih respec o he lagged comovemen effec; we find negaive and significan exposure o he US marke index wih one lag for all ADRs. This is because ADRs are clearly overreacing o innovaions in he S&P 500 Index. This finding reinforces he sudy of Kim e al (2000), who repored ha he ADRs response o he innovaion of he S&P 500 is large, posiive and highly significan a day 0, and followed by a large, significan negaive price response on day 1. Third, we have provided he evidence ha apar from counry specific facors such as local marke impac, firm specific aribues such as firms ownership srucure would also affec he ADRs price differenials. Since par of he Chinese ADRs lised A shares in Shanghai afer hey lised H shares and ADRs, we are able o examine he impac of he difference in he ownership srucure. Wih respec wih he reurn disribuions and reurn spread, we showed an obvious srucural break beween he Chinese ADRs wih A shares and hose wihou A shares. We rejeced he equaliy of reurn disribuion for mos of he ADRs wih A shares, while rejeced he equaliy of reurn disribuion for only par of he ADRs wihou A shares. In erms of he descripive saisics of reurn spread, we found for all he Chinese ADRs wih A shares bu only par of he ADRs wihou A shares, have negaive skewness in heir reurn spread. This means he ADRs wih A shares end o have lower reurn han heir underlying H shares. This finding reinforces he Invesors Recogniion Hypohesis by Meron (1987), who argued ha expeced 187

188 reurn of he firm s sock decrease wih he size of he invesor s shareholder base. Furher, wih regard o he comovemen effec, he ADRs wih A shares and hose wihou A shares are differen in erms of he magniude of he comovemen effec. The Chinese ADRs wihou A shares are usually have larger correlaion wih he US and Hong Kong marke indices, han hose wih A shares. This indicaes ha he ADRs wihou A shares end o be more closely correlaed wih boh marke reurns. Furher, for he Chinese ADRs wih A shares lised in Shanghai, we also considered he Shanghai marke reurn, and found isolaed marke impacs from he domesic sock marke on hree ADRs. Fourh, we have showed differen liquidiy risk and illiquidiy cos are he facors deermining he ADRs price differenials. Our invesigaion of he liquidiy effec sared from he comparison of he marke microsrucure and rading coss of he China s domesic sock exchanges and Hong Kong sock exchange. We also compared he implici rading coss of he hree China-relaed sock exchanges wih hose of he US sock exchanges. The resuls clearly showed he NYSE and NASDAQ have he lowes implici rading coss. Illiquidiy reflecs he impac of order flow on price, namely he discoun ha a seller concedes or he premium ha a buyer pays when execuing a marke order, which resuls from adverse selecion coss and invenory coss. Therefore, we employed a measure of he raio of he daily absolue reurn o he dollar value of rading volume on ha day as Amihud (2002) o measure daily illiquidiy coss. On he oher hand, Johnson (2007) demonsraed ha he scale of liquidiy innovaions (liquidiy risk) is posiively relaed o volume, because 188

189 inuiively, large changes in liquidiy canno occur wihou high rading volume, and a small amoun of rading volume mus imply a small change in liquidiy. Therefore, we use rading volume as alernaive measure of liquidiy risk. Our findings demonsraed rading volume is a beer proxy han illiquidiy in explaining he ADRs price differenials. This finding also provided evidence o he heory of liquidiy ha he difference in he liquidiy risk beween he ADRs and heir underlying shares can cause wo securiies have differen prices. Finally, we have given he proof ha differences in he invesors senimen wih bad news cause differen volailiy beween he ADRs and heir underlying shares. We have examined he heeroscedasiciy of reurn series and applied wo General Auoregressive Condiional Heeroskedasiciy (GARCH) models o measure reurn volailiy. The wo GARCH models we used in his hesis are known as asymmeric GARCH models o capure asymmeric characerisics of he posiive/negaive shock (namely good/bad news). We found ha he Chinese ADRs and heir H shares are clearly differen in erms of he leverage effec on bad news. We showed ha he leverage effec of bad news for he ADRs is much bigger han ha for he underlying H shares. This finding suppors he Invesor s Senimen Hypohesis proposed by De Long e al. (1990) and Shleifer and Vishny (1997), which argued sock s price are likely o be affeced by invesor s senimen. However, here also exis some limiaions of his sudy. For example, we could make some improvemens in liquidiy proxy by using he moving variance of rading volume, which exacly measures he change of liquidiy o measure liquidiy 189

190 risk. On he oher hand, in spie of ILLIQ as repored being more likely a noisy measure, we also suspeced ha he saisically insignifican resuls of ILLIQ may be due o our use of daily daa, which may increase he variance of ILLIQ daa ses, and lower he significance level. Furher, alhough we have provided evidence for SIAH when examining volume-volailiy relaion, we have only found significan Granger causaliy from volume o volailiy. While he academic lieraure generally argues ha volume causes price change and hus volailiy, he sree percepion is volailiy aracs volume. Some papers repored non-linear Granger causaliy exised eiher from volume o volailiy or he converse by employing advanced mehods; we are ineresed in a furher sudy by applying alernaive mehods in fuure. 190

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