J. of Multi. Fin. Manag. 16 (2006) 232248
Market segmentation and price differentials between Ashares and H shares in the Chinese stock markets
Yuming Li a,, Daying Yan b, Joe Greco aa Department of Finance, College of Business and Economics, California State University,
800 N State College Building, Fullerton, CA 92834, USAb School of Economics, Institute of International Economics, Nan Kai University, Tian Jin, PR China
Received 26 July 2004; accepted 29 July 2005Available online 22 September 2005
We find that the risk premiums associated with the Hong Kong and mainland Chinese markets in a two-factor model successfully explain the cross section of returns on the A and H shares. Discounts of H-shareprices relative to A-share prices are related to the contemporaneous movements of the H-share local marketindex relative to the A-share local market index, especially during the period of the Asian financial crisis,as well as the spread of savings rates between Hong Kong and mainland China. The evidence suggests thatthe risk premiums associated with the segmented A-share and H-share markets exert crucial impacts on theprice differentials between the two classes of shares. 2005 Elsevier B.V. All rights reserved.
JEL classication: G14; G15Keywords: Cross-listed shares; Price discount puzzle; Market risk premiums
The rapid openness of Chinese capital markets has attracted cross-border portfolio invest-ment, while the explicit institutional barriers may determine the actual efficiency of internationaldiversification. This prompted some recent literature to explore the distinct price behaviors ofstocks that are simultaneously traded in Chinas segmented markets. Among these studies, onecontentious issue is the price differentials among different classes of shares. One pioneer work
Corresponding author.E-mail address: firstname.lastname@example.org (Y. Li).
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Y. Li et al. / J. of Multi. Fin. Manag. 16 (2006) 232248 233
by Bailey (1994) documents that class B shares traded by foreign investors are sold at discountsrelative to class A shares traded by domestic investors, a phenomenon that is inconsistent with theprice premiums commonly found in other countries (e.g., Bailey and Jagtiani, 1994; Domowitzet al., 1997; Stulz and Wasserfallen, 1995; Bailey et al., 1999).
Several explanations have been provided for this exception. The first is based on the discount-pricing model. Bailey (1994) argues that the lower required returns of Chinese citizens due to thelimited investment opportunities might have an effect. Bailey (1994) further suggests that sincethe political and macroeconomic risks peculiar to the B-share markets are undiversifiable to theprimary foreign investors, they may add potential risk premiums on B shares and discount theprices of B shares heavily as compensation for this systemic risk. Bergstrom and Tang (2001)argue that clientele bias, foreign exchange risks and risk-free return differentials can deter thediversification benefits of foreign investments particularly in the B-share market.
The second hypothesis is invoked by the investor sentiment notions introduced by Lee et al.(1991). Bailey (1994) proposes that the unseasoned or unduly optimism of domestic investorsmay drive the overpricing of A-share. A later work by Ma (1996) demonstrates that the A-shareprices are positively related to domestic beta risk, implying the risk-seeking behavior of Chineseinvestors.
The third strand of theories centers on demand and supply of shares in segmented markets.Sun and Tong (2000) argue that the co-existence of H shares and red chips as alternatives to Bshares for foreign investors makes the demand for B shares quite price elastic, leading to lowequilibrium prices of B shares. Indeed, the exceptional discount on foreign-only shares in Chinacomplements the argument of Stulz and Wasserfallen (1995), who attribute the price premium tothe inelastic demand of foreigners.
This article extends the studies on the Chinese stock markets by investigating the pricediscounts of H shares relative to A shares. As documented by Sun and Tong (2000), the pricepremiums or discounts of B shares and H shares tend to move together over time and H sharestraded in the Hong Kong market offer substitutes for B shares traded in mainland China. Hence,an understanding of the price discounts of H shares relative to A shares should help resolve theprice discount puzzle for both B shares and H shares of Chinese firms. Unlike A shares and Bshares which are traded in the same stock exchanges within mainland China, A shares and Hshares are segmented in terms of the stock ownership as well as the listing and trading locations.Specifically, while A shares are traded in mainland Chinese stock exchanges by local investors,H shares are owned and traded by investors in Hong Kong. The unique nature of segmentationbetween A shares and H shares suggests that the price discounts of H shares to A shares may beexplained by the influence of the local market performance.
More formally, we examine whether and how the differences in market risk premiums, inter-est rates and exchange rates could induce the substantive price differentials. Although in ourtime-series model the explanatory factors reflect market-wide information, the tests are mainlyperformed at the company-specific level over a long sample horizon. In this way our results facil-itate closer inspection of stylized price differentials between A shares and H shares without thecost of statistical reliability.1 Our paper indeed reveals that the firm-specific price discounts of Hshares relative to A shares are closely correlated with the difference in the movements between thecontemporaneous Hang Seng Stock Index and the Shanghai Stock Index, and the spread between
1 Bergstrom and Tang (2001) conduct similar regressions, yet only in an aggregate level partly due to the limitation ofthe sample horizon.
234 Y. Li et al. / J. of Multi. Fin. Manag. 16 (2006) 232248
the Hong Kong and mainland Chinese interest rates, both of which are crucial constituents ofmarket risk premiums.
This paper is also motivated by recent literature on the effects of the Asian financial crisison financial markets. Froot et al. (2001) document that while international investors did notabandon emerging markets during the crisis, daily inflows into all emerging markets over theJuly 1997July 1998 period averaged only 40% for all emerging markets and 30% for Asiacompared with their pre-crisis (19941997) levels. Lin and Swanson (2004), however, find littleevidence of significant crisis effects under information dissemination. We report that the Asianfinancial crisis exerts an economically significant impact on the volatility of the Hong Kongequity market and H-share prices, while the crisis fails to affect the mainland Chinas equitymarket and cross-listed A shares traded in mainland China. The evidence is consistent with theasset pricing theory in segmented markets, which suggests that the risk premiums associatedwith the segmented A-share and H-share markets exert crucial impacts on the price differentialsbetween the two classes of shares. Our results confirm the empirical findings that stock returnsfrom different classes of shares are sensitive to distinct markets (Hietala, 1989; Chen et al.,2001). The results are also in accord with empirical findings that asset prices are affected by thelocation of trade (e.g., Froot and Dabora, 1999; Chan et al., 2003).
The rest of paper proceeds as follows. Section 2 briefly outlines the institutional settings ofChinese equity markets and the construction of the sample. Section 3 examines the relationsbetween stock returns and market-wide factors. Section 4 performs analysis of price differentialsbetween A shares and H shares. The final section concludes the article.
2. Data and hypotheses
2.1. Institutional settings
Alongside the well-known B shares traded in the Shanghai and Shenzhen stock exchanges(SHSE and SZSE), there is another class of stocks called H shares that allows Hong Kong andforeign investors access to mainland Chinese enterprises. Currently H shares refer to stocks ofmainland China-established companies traded directly in Hong Kong Stock Exchange (HKSE).2A smaller group of Chinese firms are listed on the New York Stock Exchange (NYSE) in the formof ADRs, also known as N shares. Although B, H and N shares are all intended to attract foreignfunds, as H and N shares are issued and traded outside mainland China and therefore must complywith the additional legal disclosures set by the trading markets, the co-existence of different classesof shares creates more sophisticated features of market segmentation in Chinese capital markets.In the rest of the paper, we will document some common and distinct price behaviors of the stocksthat are dual-listed in mainland and Hong Kong markets and provide possible explanations forthe evidence on price discounts.
2.2. Data and summary statistics
We first collect daily stock prices of A shares and H shares from Datastream database fromJanuary 1997 to March 2002. Then firms that have issued both A shares in SHSE or SZSE andH shares in HKSE at the beginning of the sample period are selected, yielding an intersection of
2 See Poon and Fung (2000) for an exhaustive listing of all H shares.
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13 firms. In spite of the limited size, the sample covers a wide cross section of Chinese industriesand should still be considered as a representative sample of Chinese firms.
Because all H shares are traded in the HKSE and 10 out of 13 A shares in the sample are tradedin the SH