Market segmentation and Price differentials of dual-listed shares: An empirical study on Chinese A-Shares and H-Shares

BY

Chau Man Tai Andy 05000084 Major in Finance

An Honours Degree Project Submitted to the School of Business in Partial Fulfillment of the Graduation Requirement for the Degree of Bachelor of Business Administration (Honours)

Hong Kong Baptist University

April 2008

Acknowledgement

First of all, I would like to thank my Honors Project Supervisor Dr. Billy Mak for his insightful and generous advice on this project. His expertise in research area gives me lots of ideas and suggestions which help my report to merit. Without his kind support, this study could not be accomplished as a valuable piece.

I would like to express my thankfulness and appreciation for all the teaching staff in the Finance Department who have given me valuable input to my studies and countless opportunities to participate various kinds of activities in the University.

I would also like to express my sincere thank to my classmates, friends, family members for their encouragement throughout the whole research process.

Content
ABSTRACT........................................................................................................................................- 1 1. 2 INTRODUCTION ....................................................................................................................- 2 LITERATURE REVIEW ........................................................................................................- 4 2.1. 2.2. 2.2.1. 2.2.2. 3. 4. PRICE PREMIUM OF FOREIGN SHARES ............................................................................. - 4 PRICE DISCOUNT OF FOREIGN SHARES ............................................................................ - 4 Price discount of B-shares ..........................................................................................- 4 Price discount of H-shares..........................................................................................- 5 -

INSTITUTIONAL SETTING .................................................................................................- 6 CROSS-SECTIONAL ANALYSIS.........................................................................................- 9 4.1. 4.1.1. 4.1.2. 4.1.3. 4.1.4. 4.1.5. 4.2. HYPOTHESES .................................................................................................................... - 9 Information asymmetry between domestic and foreign investors............................- 10 Market capitalization ................................................................................................ - 11 Liquidity..................................................................................................................... - 11 Supply of shares ........................................................................................................- 12 Diversification benefit ...............................................................................................- 13 EQUATION OF MULTIPLE REGRESSION .......................................................................... - 13 -

5.

DATA ......................................................................................................................................- 14 5.1. DESCRIPTIVE STATISTICS .............................................................................................. - 15 -

6. 7.

REGRESSION RESULT AND DISCUSSION ....................................................................- 17 CONCLUSION.......................................................................................................................- 22 -

REFERENCES.................................................................................................................................- 23 -

Abstract

This paper examines the relationship between market segmentation and price differentials of dual-listed stocks in Chinese stock markets. By the end of March 2008, there are 53 China enterprises that have dual-listed in China (A-shares) and Hong Kong (H-shares). Under Law of One Price, A-share prices should be the same as H-share prices in an efficient market. However, A-share and H-share markets are segmented, which leads to H-share prices are usually trading at a discount compared to A-share prices. This paper demonstrates that company specific factors related to information asymmetry, liquidity, market capitalization and demand of shares are important factors to explain the price discount of H-shares.

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1. Introduction

Due to the integration of financial industry, many companies not only can raise capital in the domestic market, they also can raise capital by listing their shares in foreign markets. Thus, these companies are dual-listed in domestic and foreign markets. Under the theory of Law of One Price, the dual-listed shares should not have price differential in an efficient market. It is because both shares belong to the same company, so the investors have the same shareholders rights and they receive the same future dividends. However, if the domestic and foreign markets are segmented, the stock prices differential between these markets can be quite substantial (Eun and Janakiramanan, 1986). Market segmentation generally can be explained by information asymmetry between domestic and foreign investors, difference in language, political and macroeconomic risk, clientele bias, liquidity and others.

Based on previous studies of dual-listed shares of developed capital markets (America and Europe), market segmentation commonly results in price premium of foreign shares relative to home shares (Bailey and Jagtiani, 1994; Stulz and Wasserfallen, 1995; Domowitz, Glen and Madhavan, 1997). In contrast to the mainstream researches, Bailey (1994) first discovers that the price of B-shares, which are traded by foreign investors but in the same trading location as A-shares, are

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trading at a discount compared to the price of domestic A-shares. Furthermore, Sun and Tong (2000) and Mei, Scheinkman and Xiong (2005) show that both B-Shares and H-Shares have significant price discounts relative to A-shares. By the end of March 2008, nearly all H-shares prices are trading at a discount compared to A-shares and the mean price discount is about 38% (Table 1).

Table 1: Distribution of daily average price discount (April 2003March 2008) Daily average discounts -20%Discount0% 0%Discount20% 20%Discount40% 40%Discount60% 60%Discount80% Mean Discount SHSE (n=46) SZSE (n=7) Whole sample (n=53) 2 5 19 15 5 38.01% 0 2 1 1 3 44.39% 2 7 20 16 8 38.85%

The structure of B-Shares and H-Shares are similar, but the trading locations of the two classes of shares are different. The trading activities of B-Shares take place in Shanghai and Shenzhen, which is the same as the A-Shares, while the trading activities of H-shares are in Hong Kong. An interesting question is whether the price discount of H-shares is caused by the same factors of the price discount of B-shares. Bergstorm and Tang (2001) shows that the price discount of B-Shares can be explained by information asymmetry between foreign investors and domestic investors, liquidity effects, diversification effects, clientele bias, risk-free return differentials between foreign and domestic investors, and foreign exchange risks. This -3-

paper examines the hypotheses of the above factors (Bergstorm and Tang, 2001) and check whether they can explain the price discount of H-shares.

Literature Review

2.1. Price premium of foreign shares

The problem of price premium of foreign shares under market segmentation has been started analyzing since 1970. Hietala (1989) uses a modified CAPM model to show an unrestricted stock is traded at a price premium relative to the corresponding restricted stock if foreign investors require a lower rate of return on this stock than domestic investors do. She also finds that the size of the premium is determined by the international and domestic beta of the stock. Domowitz, Glen and Madhavan (1997) find that the price premium for foreign shares is positively related to proxies for foreign demand and is negatively related to the relative supply of foreign shares, but the proxy for relative liquidity cannot explain the price premium.

2.2. Price discount of foreign shares 2.2.1. Price discount of B-shares

The first price discount of foreign shares is documented by Bailey (1994). He finds the price discounts on B-shares relative to A-shares are inconsistent with premiums observed in other Asian capital markets. Sun and Tong (2000) suggests that -4-

foreign investors are important to the B-share price discount phenomenon. Foreign investors demand for B-shares is quite elastic because Red Chip shares and H-shares in Hong Kong stock market are good substitutes for B-shares. In addition, the difference in expectations of firms growth rates between Chinese investors and foreign investors also is a major factor to explain the price differential. He adds that return volatility, bond supply, share supply and liquidity have explanatory powers to this phenomenon. Poon, Firth and Fung (1998) find that the relative liquidity of B-shares to A-Shares is negatively related to the price discount, and they comment that the price discount is mainly due to the illiquidity of B-shares. Chakravarty, Sarkar and Wu (1998) show that information asymmetry between local and foreign investors is a crucial factor to explain the price discount of B-shares.

2.2.2. Price discount of H-shares

Wang and Jiang (2004) claim market segmentation is mainly induced by ownership restriction and exchange control in mainland China. They document a large time-varying H-share price discount relative to A-shares and this discount is highly correlated with the domestic and foreign stock market indices and relative market illiquidity. They also show that H-share price discount is positively correlated with the expected devaluation in the Chinese currency. Y. Li et al. (2006) illustrate that the

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H-shares price discount is mainly attributable to the deviation in the systemic risk premiums of the local markets.

3. Institutional setting

The Shanghai Stock Exchange (SHSE) and Shenzhen Stock Exchange (SZSE) were established on November 26, 1990 and April 11, 1991 respectively. The two exchanges are independent and dual-listing between them is not permitted. However, dual-listed is allowed under the same exchange in the form of B-shares. Stocks listed in SHSE and SZSE can cross list in Hong Kong stock market in the form of H-shares. Therefore, there are 3 classes of shares issued by China enterprises in the form of A-shares, B-shares and H-shares. A-shares are domestic shares that are restricted to domestic investors and traded with Chinese yuan; B-shares and H-shares are both foreign shares that are restricted to foreign investors and traded with US dollars and HK dollars respectively. In addition, Qualified Foreign Institutional Investor (QFII) was launched in 2002, approved foreign investors were allowed to invest in A-share market but with a limited quota of fund. Qualified Domestic Institutional Investor (QDII) was launched in 2006, approved domestic investors were allowed to invest in foreign market but with a limited quota of fund.

History of Hong Kong stock market dates back 100 years history ago. Now,

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Hong Kong stock market is a mature, well established market with strict listing requirements and information disclosure. Compare with Hong Kong stock market, China stock market is still green and with poor information disclosure. The market is dominated by retail investors and most policies are controlled by the government.

Table 2: The China stock market constitution Hong Kong Main Board No. of listed companies No. of listed H shares No. of listed red-chips stocks Total no. of listed securities Total market capitalization (Bil. dollars) Total negotiable capitalization (Bil. dollars) Average P/E ratio (Times) 1,055 107 88 6,508 HKD 16,825 n.a. 13.68 GEM 189 40 5 193 HKD 113 n.a. 17.18 Shanghai A Share 851 n.a. n.a. n.a. B Share 54 n.a. n.a. n.a. Shenzhen A Share 676 n.a. n.a. n.a. B Share 55 n.a. n.a. n.a.

RMB 18,046 RMB 89 RMB 4,453 RMB 101 RMB 5,222 39.45 RMB 89 RMB 2,244 RMB 100 41.85 39.34 16.82

From table 2, there are 147 H-shares listed in Hong Kong of which 53 stocks are dually listed in China and Hong Kong. One important item is that the some shares in China are not tradable/transferable. These shares are held by the government or legal person and employee. As a result, the total negotiable capitalization (shown in the table 2) is the market capitalization of tradable shares.

Table 3: Dual-listed stocks in A- and H-share Markets (53 companies) -7-

H-share code 00042 00168 00177 00187 00300 00317 00323 00338 00347 00350 00358 00386 00390 00525 00548 00553 00588 00670 00719 00753 00763 00857 00874 00902 00914 00921 00939 00991 00995 00998 01033 01053 01055 01065 01071 01072 01088 01108 01138 01171 01186 01398

A-share code

Name

H-share listing date 06/07/1995 15/07/1993 27/06/1997 06/08/1993 07/12/1993 06/08/1993 03/11/1993 26/07/1993 24/07/1997 02/02/1996 12/06/1997 19/10/2000 07/12/2007 14/05/1996 12/03/1997 02/05/1996 14/05/1997 05/02/1997 31/12/1996 15/12/2004 09/12/2004 07/04/2000 30/10/1997 21/01/1998 21/10/1997 23/07/1996 27/10/2005 21/03/1997 13/11/1996 27/04/2007 29/03/1994 17/10/1997 31/07/1997 17/05/1994 30/06/1999 06/06/1994 15/06/2005 08/07/1994 11/11/1994 01/04/1998 13/03/2008 27/10/2006

A-share listing date 13/12/1995 27/08/1993 16/01/2001 06/05/1994 03/01/1994 28/10/1993 06/01/1994 08/11/1993 25/12/1997 10/12/1996 11/01/2002 08/08/2001 03/12/2007 22/12/2006 25/12/2001 18/11/1996 16/10/2006 05/11/1997 06/08/1997 18/08/2006 18/11/1997 05/11/2007 06/02/2001 06/12/2001 07/02/2002 13/07/1999 25/09/2007 20/12/2006 07/01/2003 27/04/2007 11/04/1995 28/02/2007 25/07/2003 30/06/1995 03/02/2005 10/10/1995 09/10/2007 31/10/1995 23/05/2002 01/07/1998 10/03/2008 27/10/2006

000585.SZ Northeast Electric Development Co. Ltd. 600600.SS Tsingtao Brewery Co. Ltd. 600377.SS Jiangsu Expressway Co. Ltd. 600860.SS Beiren Printing Machinery Holdings Ltd. 600806.SS Shenji Group Kunming Machine Tool Co. Ltd. 600685.SS Guangzhou Shipyard International Co. Ltd. 600808.SS Maanshan Iron & Steel Co. Ltd. 600688.SS Sinopec Shanghai Petrochemical Co. Ltd. 000898.SZ Angang Steel Co. Ltd. 000666.SZ Jingwei Textile Machinery Co. Ltd. 600362.SS Jiangxi Copper Co. Ltd. 600028.SS China Petroleum & Chemical Corporation 601390.SS China Railway Group Ltd. 601333.SS Guangshen Railway Co. Ltd. 600548.SS Shenzhen Expressway Co. Ltd. 600775.SS Nanjing Panda Electronic Co. Ltd. 601588.SS Beijing North Star Co. Ltd. 600115.SS China Eastern Airlines Corporation Ltd. 000756.SZ Shandong Xinhua Pharmaceutical Co. Ltd. 601111.SS Air China Ltd. 000063.SZ ZTE Corporation 601857.SS PetroChina Co. Ltd. 600332.SS Guangzhou Pharmaceutical Co. Ltd. 600011.SS Huaneng Power International, Inc. 600585.SS Anhui Conch Cement Co. Ltd. 000921.SZ Hisense Kelon Electrical Holdings Co. Ltd. 601939.SS China Construction Bank Corporation 601991.SS Datang International Power Generation Co., Ltd. 600012.SS Anhui Expressway Co. Ltd. 601998.SS China CITIC Bank Corporation Ltd. 600871.SS Sinopec Yizheng Chemical Fibre Co. Ltd. 601005.SS Chongqing Iron & Steel Co. Ltd. 600029.SS China Southern Airlines Co. Ltd. 600874.SS Tianjin Capital Environmental Protection Co. Ltd. 600027.SS Huadian Power International Corporation Ltd. 600875.SS Dongfang Electric Corporation Ltd. 601088.SS China Shenhua Energy Co. Ltd. 600876.SS Luoyang Glass Co. Ltd. 600026.SS China Shipping Development Co. Ltd. 600188.SS Yanzhou Coal Mining Co. Ltd. 601186.SS China Railway Construction Corporation Ltd. 601398.SS Industrial and Commercial Bank of China Ltd.

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01898 01919 02318 02338 02600 02628 02866 02883 03328 03968 03988

601898.SS China Coal Energy Co. Ltd. 601919.SS China COSCO Holdings Co. Ltd. 601318.SS Ping An Insurance (Group) Co. of China Ltd. 000338.SZ Weichai Power Co. Ltd. 601600.SS Aluminum Corporation of China Ltd. 601628.SS China Life Insurance Co. Ltd. 601866.SS China Shipping Container Lines Co. Ltd. 601808.SS China Oilfield Services Ltd. 601328.SS Bank of Communications Co., Ltd. 600036.SS China Merchants Bank Co., Ltd. 601988.SS Bank of China Ltd.

19/12/2006 30/06/2005 24/06/2004 11/03/2004 12/12/2001 18/12/2003 16/06/2004 20/11/2002 23/06/2005 22/09/2006 01/06/2006

01/02/2008 26/06/2007 01/03/2007 30/04/2007 30/04/2007 09/01/2007 12/12/2007 28/09/2007 15/05/2007 09/04/2002 05/07/2006

4. Cross-sectional analysis

Cross-sectional model is used because it can give an overall behavior of dual-listed A- and H-Shares at once. The model investigates whether the company specific factors related to information asymmetry, diversification, liquidity, market capitalization and demand of shares can explain the price discount of H-Shares. The dependent variable is the average daily price discount for individual companies, i.e.

DISit = (PA,it PH,it Xt)/ PA,it where PA,it and PH,it are firm is A- and H-shares closing price at time t, and Xt is the exchange rate between Chinese RMB and the Hong Kong dollar.

4.1. Hypotheses

The following independent variables are potential causes of H-share price discount:

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4.1.1. Information asymmetry between domestic and foreign investors

Chakravarty, Sarkar and Wu (1998) shows that the price discount on B-shares is 1.) negatively related to the covariance of returns of A- and B-shares divided by the variance of price of A-share; 2.) positively related to the variance of B-share returns. As B- and H-share are similar in nature, it is possible that H-shares will exhibit the same features as B-shares. For that reason, the above arguments are set to be the hypotheses for testing the model of H-share price discount:

1. 2.

negatively related to SHAit = [Cov(rA,it, rH,it) / Var(PA,it)] ; positively related to VARHit = Var(rH,it)

where rA,it and rH,it are the return of firm is A- and H-shares at time t.

Intuitively, SHAit measures the return sensitivity of H shares to the A shares. A high value of Cov(rA,it, rH,it) implies that A share returns are informative about H share returns, and foreign investors can more easily infer the H-share price from the A-share price even information is not accessible by foreign investors.. A high value of Var(PA,it) means that the price of A shares is very noisy, which leads foreign investors difficult to learn the future return precisely. Therefore, SHAit should be negatively related to the H-share discount. VARHit measures the volatility of H-share. A high value of Var(rH,it) makes foreign investors difficult to make prediction on the future - 10 -

return. So, SHAit should be positively related to the H-share discount.

4.1.2. Market capitalization

Market capitalization (SIZEit) is another proxy to determine the information asymmetry. Companies with high market capitalization are usually analyzed by foreign institutional investors and these companies also have good media coverage. Thus, the information of large-cap companies can be obtained easily. However, small-cap companies are relatively less transparent as media and foreign institutional investors have less interest on them. Therefore, SIZEit should be negatively related to the H-share discount.

4.1.3. Liquidity

Liquidity measures the degree of readiness to which the shares can be bought or sold in the market without affecting the price. Two common liquidity proxies are used to examine whether they are the sources of H-share price discount: 1) turnover rate and 2) bid-ask spreads.

The first liquidity proxy is turnover rate. The relative turnover rates of A-share to H-shares is employed in the hypothesis: TOit = (VOLA,it / TBA,it) / (VOLH,it / TBH,it), where VOLA,it and VOLH,it are firm is A- and H-shares trading volume at time t and

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TBA,it and TBH,it are firm is A- and H-shares tradable shares at time t. The higher the turnover rate of A-shares to H-shares, the higher the liquidity of A-shares to H-shares. As a result, A-shares should have a better pricing over H-shares. Thus, TOit should be positively related to the H-share discount.

The second liquidity proxy is bid-ask spreads. The relative bid-ask spreads of H-share to A-shares is employed in the hypothesis: SPR it = SPRH,it / SPRA,it. The larger the spreads of H-shares to A-shares, the higher transaction cost in H-shares to A-shares. So, A-shares should have a better pricing over H-shares. As a result, SPR it should be positively related to the H-share discount. (As the bid-ask spreads cannot be obtained easily, an alternative method is used to estimate the bid-ask spreads. Corwin and Schultz (2008) develop a new way to estimate bid-ask spreads from daily high and low prices. The bid-ask spreads are calculated the following equation:

where Ht and Lt are the day high and day low of the share.

4.1.4. Supply of shares

In China stock market, there are limited investment opportunities and also few

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substitutes to replace shares, so the elasticity of share demand is low. However, investors in Hong Kong can invest various types of securities and thus the elasticity of share demand is high. Therefore, the relative supply of A-shares to H-shares is another proxy to examine the H-shares discount: SUPit = TBA,it / TBH,it, where TBA,it and TBH,it are firm is A- and H-shares tradable shares at time t. The lower the value of SUPit, the fewer the demand for H-shares to A-shares, and the price differential will be enlarged. As a result, SUPit should be negatively related to the H-share discount.

4.1.5. Diversification benefit

With the use of the portfolio theory, foreign investors require a lower return on H shares if the shares provide diversification benefits in their portfolio. The correlation of H-share return and foreign market portfolio return Corr(rH,it, rMSCI,t)should be a proxy of diversification benefits DIVMSCI,it. The higher the correlation of H-share return and MSCI return, the lower the diversification benefits. Thus, H-shares demand will decrease and so does the price. Therefore, Corr(rH,it, rMSCI,t) should be positively related to the H-share discount.

4.2. Equation of multiple regression

For convenience, it is better to convert the above hypothesis in to an equation: DISit = a0 + a1SHAit + a2VARHit + a3SIZEit + a4TOit + a5SPR it + a6SUPit + a7 DIVMSCI,it +it - 13 -

5. Data

The data have been collected for the period from April 2003 to March 2008 in respect of 53companies, 7 of which are listed on SZSE and 46 on SHSE. The data is mainly obtained from Reuters database and supplemented by Yahoo and Sina. The test is done on a monthly basis. A sample size of 1893 has been set. The data used are daily closing prices, with those of H-shares being converted into Chinese yuan with daily closing spot exchange rates. Except covariances and variances, daily numbers are computed first, and the monthly numbers are average of daily numbers of each month for all variables. Covariances and variances are computed using daily returns and daily prices of each month.

The total market capitalization of each firm cannot be obtained directly. By using the tradable shares of A-shares and H-shares, the weighted average price of the firm can be calculated and it is then multiplied by the total number of shares issued. Thus, a proxy of total market capitalization can be obtained. The Morgan Stanley Capital International World Index (MSCI World) is chosen to represent the market portfolio. Moreover, as H-shares are traded in Hong Kong and it is reasonable to add Hang Seng Index (HSI) to be an alternative representation of market portfolio.

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5.1. Descriptive statistics

Detail descriptive statistics is shown in Table 4. Some numbers in the table are worth to discuss. First, all variables have a higher coefficient of variation than discount. This shows that the discounts of H-shares are less dispersed from the mean than other variables. Moreover, the statistics show that not all companies experienced price discount during the sample period, some were trading at a premium relative to the A-shares price. But the occurrences of price premium were usually not sustainable, so it would not affect the analysis.

The maximum relative turnover rate looks excessive. It may be explained by low tradable volume in A-shares compare to high tradable volume in H-shares. When the demand of A-shares suddenly increases, the relative turnover rate may also surge. Furthermore, the coefficient of variation is still acceptable, so it is not a concern. However, the H-share return sensitivity seems to be unreliable because the coefficient of variation is surprisingly high. Special attention on this variable is needed when conducting regression.

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Table 4: Descriptive statistics of variables (values are calculated on a monthly basis) Mean 0.4249 0.00616 0.00136 97007.72 6.4712 1.0289 0.5518 0.1772 0.4335 0.3547 0.1807 0.4672 0.9221 3.3013 167.7929 8.4687 3.3431 0.9982 0.9848 12653.30 3292984.00 0.00079 0.03407 0.00001 493.60 0.1029 0.0125 0.0280 -0.9184 -0.8980 0.00104 2.09819 -0.30823 0.4270 0.8960 -0.2109 0.2371 0.05506 0.00216 289967.00 11.2702 0.5805 0.4813 0.2681 0.2960 Median Maximum Minimum Std. Dev. Skewness -0.192 30.110 6.913 5.193 6.240 2.577 2.198 -0.1698 -0.7537 Coefficient of variation 0.558 8.941 1.590 2.989 1.742 0.564 0.872 1.5135 0.6829

Detail

Variable

Mathematical

representation

Discount

DISit

(PA,it PH,it Xt)/ PA,it

H-share return

sensitivity Var(rH,it) SIZEit

SHAit

Cov(rA,it, rH,it) / Var(PA,it)

H-share return variance

VARHit

Market capitalization

(million)

SIZEit

Relative turnover rate

(VOLA,it / TBA,it) /

TOit

(VOLH,it / TBH,it)

Relative spread TBA,it / TBH,it

SPR it

SPRH,it / SPRA,it

Relative supply of shares

SUPit

Correlation of H-share

return with MSCI return DIVMSCI,it Correlation of H-share

Corr(rH,it, rMSCI,t)

return with HSI return

DIVHSI,it

Corr(rH,it, rHSI,t)

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Table 5: Pairwise correlation DISit DISit SHAit VARHit SPR it TOit DIVmsci,it SIZEit SUPit DIVhsi,it 1.000 0.056 0.127 0.137 0.109 -0.113 -0.205 -0.096 -0.138 SHAit 0.056 1.000 0.254 -0.015 0.034 -0.059 -0.024 -0.029 -0.039 VARHit SPR it 0.127 0.254 1.000 0.102 -0.022 0.095 -0.022 0.034 0.131 0.137 -0.015 0.102 1.000 -0.187 -0.035 -0.084 -0.070 0.011 TOit 0.109 0.034 -0.022 -0.187 1.000 -0.008 -0.028 0.029 -0.110 DIVmsci,it SIZEit -0.113 -0.059 0.095 -0.035 -0.008 1.000 0.133 -0.013 0.474 -0.205 -0.024 -0.022 -0.084 -0.028 0.133 1.000 -0.159 0.301 SUPit -0.096 -0.029 0.034 -0.070 0.029 -0.013 -0.159 1.000 -0.041 DIVhsi,it -0.138 -0.039 0.131 0.011 -0.110 0.474 0.301 -0.041 1.000

From Table 5, The highest correlation between two independent variables is 0.474. Multicollinearity is not likely to occur in the model. In addition, the Variance inflation factors (VIFs) of all independent variables are less than 2, this further consolidates that multicollinearity is not a problem in the model. However, another two problems may arise because of the use of cross sectional model. Autocorrelation and heteroskedasticity are two common problems when cross sectional model is employed. In the model, both autocorrelation and heteroskedasticity are observed by Durbin-Watson test and White test. In order to solve the problems, the Newey-West Heteroskedasticity and Autocorrelation Consistent Covariance Matrix Estimation is used in the regression.

6. Regression result and discussion

The results shown in Table 6 are estimated by OLS method and the model is

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corrected by Newey-West Heteroskedasticity and Autocorrelation Consistent Covariance Matrix Estimation. Model 1 includes all independent variables. Model 2 is similar but with MSCI replaced by HSI. Model 3 includes the variables that have been found significant by stepwise regression. The independent variables in all models are jointly significant as all null hypotheses are rejected under F-test. All independent variable have expected sign except SHAit and DIVmsci,it. Only SHAit is rejected at 1% and 5% confidence level. Furthermore, the constant term is large in all models and with high t-value, this suggests that there may be more variables to add explanatory powers. Overall, the results show H-share return variance, relative tradable shares, relative spread, market capitalization and supply of shares are significant determinants of H-share discount.

In model 1 and 2, SHAit has low t-scores which indicate it is not significant. The result is not surprised. In the descriptive statistics section, SHAit is already suspected to be an appropriate independent variable because the coefficient of variation is too high. In addition, the stepwise regression also shows that SHAit is not significant. This variable may be only suitable in B-shares as done by Chakravarty, Sarkar and Wu (1998) and Bergstrom and Tang (2001). In contrast to B-shares, the A-shares and H-shares are trading in different stock exchanges and this may be the cause of insignificant of SHAit. Therefore, SHAit should be dropped from the regression model. - 18 -

Table 6: Regression result (cross sectional model, monthly data, sample size:1893) (model corrected by Newey-West Heteroskedasticity and Autocorrelation Consistent Covariance Matrix Estimation) 1 0.4028 (15.69**) 0.03545 (0.44) 13.6769 13.9195 (4.89**) 0.00276 (4.33**) 0.049044 (4.22**) -0.08403 (-3.89**) -0.07428 (-3.02**) 0.002737 (4.27**) 0.053556 (4.52**) -0.08429 (-3.90**) (4.78**) 13.3706 (4.47**) 0.002755 (4.32**) 0.049192 (4.21**) -0.08342 (-3.83**) (4.33**) (4.14**) 0.050777 0.002581 (4.38**) (0.57) 13.9419 0.04415 13.8937 (4.94**) 0.002899 (4.36**) 0.059653 (4.98**) -0.10483 (-4.79**) 12.5975 (4.53**) 0.002935 (4.38**) 0.061959 (5.11**) 13.9635 (4.88**) (15.02**) (15.74**) (16.55**) (16.38**) 0.4180 0.4031 0.3627 0.3444 0.3250 (15.21**) 2 3 4 5 6 7 0.4059 (26.59**)

Factors/Model

Expected sign

Constant term

Information asymmetry SHAit

VARHit

Liquidity

TOit

SPR it

Diversification DIVmsci,it

DIVhsi,it

Market Capitalization

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SIZEit

-0.00000016 -0.00000015 (-3.60**) (-3.26**) -0.06312 (-2.73**) 10.70% 10.60% 10.74% 9.20% 6.25% 4.91% -0.06291 (-2.68**) -0.06331 (-2.74**)

-0.00000016 (-3.61**)

-0.00000014 (-3.43**)

Supply of shares SUPit

Adj R2

1.57%

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Another issue is that the diversification benefit has an opposite sign compared with the hypotheses expected sign. And the t-value is significant at 1% confident level. If the sign is reverse, it means that the higher the correlation between H-share return and MSCI return, the lower the H-share discount. Even the diversification benefit is low, people still buy H-shares and lower the price discount of H-shares. This problem seems to be contradictory to the portfolio theory. However, if we consider the macro-economy of Hong Kong in that period, the above problem can be explained easily. The sample period is from April 2003 to March 2008. In the first half of 2003, the Hong Kong stock market was plunged by the SARS problem. Everyone was afraid of the killing disease and the confident level of the public dropped to a trough. So, the stock market experience massive selling force. In the second half of 2003, the problem of SARS was nearly solved and peoples confidence recovered to a normal level. As a result, the stock market bottomed and recovered from the over-sold position during SARS. After that, the stock market rose steadily in the coming years. In July 2005, the China government suddenly announced that the appreciation of RMB and the RMB would be linked with a basket of foreign currency. As the H-shares are denominated in HKD but the assets are settled in RMB, the appreciation of RMB will have a positive impact on the stock price. Therefore, the stock market rose kept rising from 2005 to 2007. With these two special incidents, the capital gain - 21 -

in this period has overwhelmed the diversification benefit. Not surprisingly, this is the reason to explain the negative relationship of H-discount and diversification benefit.

Other than these two variables, the others have significant explanatory powers to the H-shares discount. The highest adjusted R2 among the models is 10.74%. Looking at the increment in adjusted R2 from model 3-7, relative turnover rate, relative spread and market capitalization are strong factors in explaining the cross-sectional price differential of H-shares. The adjusted R2 may be small and there should be more explanatory variables to explain the H-share price discount. However, some of the variables are difficult to quantify such as political factors, investment behaviors between domestic and foreign investors, manipulation of shares, insider activities and more.

7. Conclusion

This paper studies the impact of market segmentation on stock prices. A number of examples are shown that foreign shares experience a price premium relative to the domestic shares. However, China B-shares give a distinct example that foreign shares are trading at a price discount relative to the domestic shares. Next, H-shares also experience a price discount and the average daily discount is 38% from April 2003 to March 2008. With the interest of what factors are causing the price discount, a cross - 22 -

sectional model is used to analyze 53 dual-listed A- and H-shares.

The result shows

that the price discount can be explained by the volatility of H-share return, relative tradable share, spread and supply of shares between A- and H-shares and market capitalization. There should be other explanatory variables of H-shares discount (such as political factors, investment behaviors between domestic and foreign investors, manipulation of shares and insider activities) as the R2 is only 10.74% and the intercept of the regression equation is high. As the A- and H-share markets become more integrated (government policy likes QDII and QFII), more explanatory factors will be available to explain the price discount in the future.

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