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. INTRODUCTION....................................................................................................................- 2 -

2 LITERATURE REVIEW........................................................................................................- 4 -

2.1. PRICE PREMIUM OF FOREIGN SHARES............................................................................. - 4 -

2.2. PRICE DISCOUNT OF FOREIGN SHARES ............................................................................ - 4 -

2.2.1. Price discount of B-shares ..........................................................................................- 4 -

2.2.2. Price discount of H-shares..........................................................................................- 5 -

3. INSTITUTIONAL SETTING.................................................................................................- 6 -

4. CROSS-SECTIONAL ANALYSIS.........................................................................................- 9 -

4.1. HYPOTHESES .................................................................................................................... - 9 -

4.1.1. Information asymmetry between domestic and foreign investors............................- 10 -

4.1.2. Market capitalization ................................................................................................ - 11 -

4.1.3. Liquidity..................................................................................................................... - 11 -

4.1.4. Supply of shares ........................................................................................................- 12 -

4.1.5. Diversification benefit ...............................................................................................- 13 -

4.2. EQUATION OF MULTIPLE REGRESSION.......................................................................... - 13 -

5. DATA ......................................................................................................................................- 14 -

5.1. DESCRIPTIVE STATISTICS .............................................................................................. - 15 -

6. REGRESSION RESULT AND DISCUSSION.................................................................... - 17 -

7. 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.

- 1 -

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

- 2 -

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 2003—March 2008)

Daily average discounts SHSE (n=46) SZSE (n=7) Whole sample (n=53)

-20%＜Discount≦0% 2 0 2

0%＜Discount≦20% 5 2 7

20%＜Discount≦40% 19 1 20

40%＜Discount≦60% 15 1 16

60%＜Discount≦80% 5 3 8

Mean Discount 38.01% 44.39% 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.

2 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

- 5 -

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,

- 6 -

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 Shanghai Shenzhen

Main Board GEM A Share B Share A Share B Share

No. of listed companies 1,055 189 851 54 676 55

No. of listed H shares 107 40 n.a. n.a. n.a. n.a.

No. of listed red-chips stocks 88 5 n.a. n.a. n.a. n.a.

Total no. of listed securities 6,508 193 n.a. n.a. n.a. n.a.

Total market capitalization

(Bil. dollars) HKD 16,825 HKD 113 RMB 18,046 RMB 89 RMB 4,453 RMB 101

Total negotiable

capitalization (Bil. dollars) n.a. n.a. RMB 5,222 RMB 89 RMB 2,244 RMB 100

Average P/E ratio (Times) 13.68 17.18 39.45 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

A-share

code Name

H-share

listing date

A-share

listing date

00042 000585.SZ Northeast Electric Development Co. Ltd. 06/07/1995 13/12/1995

00168 600600.SS Tsingtao Brewery Co. Ltd. 15/07/1993 27/08/1993

00177 600377.SS Jiangsu Expressway Co. Ltd. 27/06/1997 16/01/2001

00187 600860.SS Beiren Printing Machinery Holdings Ltd. 06/08/1993 06/05/1994

00300 600806.SS Shenji Group Kunming Machine Tool Co. Ltd. 07/12/1993 03/01/1994

00317 600685.SS Guangzhou Shipyard International Co. Ltd. 06/08/1993 28/10/1993

00323 600808.SS Maanshan Iron & Steel Co. Ltd. 03/11/1993 06/01/1994

00338 600688.SS Sinopec Shanghai Petrochemical Co. Ltd. 26/07/1993 08/11/1993

00347 000898.SZ Angang Steel Co. Ltd. 24/07/1997 25/12/1997

00350 000666.SZ Jingwei Textile Machinery Co. Ltd. 02/02/1996 10/12/1996

00358 600362.SS Jiangxi Copper Co. Ltd. 12/06/1997 11/01/2002

00386 600028.SS China Petroleum & Chemical Corporation 19/10/2000 08/08/2001

00390 601390.SS China Railway Group Ltd. 07/12/2007 03/12/2007

00525 601333.SS Guangshen Railway Co. Ltd. 14/05/1996 22/12/2006

00548 600548.SS Shenzhen Expressway Co. Ltd. 12/03/1997 25/12/2001

00553 600775.SS Nanjing Panda Electronic Co. Ltd. 02/05/1996 18/11/1996

00588 601588.SS Beijing North Star Co. Ltd. 14/05/1997 16/10/2006

00670 600115.SS China Eastern Airlines Corporation Ltd. 05/02/1997 05/11/1997

00719 000756.SZ Shandong Xinhua Pharmaceutical Co. Ltd. 31/12/1996 06/08/1997

00753 601111.SS Air China Ltd. 15/12/2004 18/08/2006

00763 000063.SZ ZTE Corporation 09/12/2004 18/11/1997

00857 601857.SS PetroChina Co. Ltd. 07/04/2000 05/11/2007

00874 600332.SS Guangzhou Pharmaceutical Co. Ltd. 30/10/1997 06/02/2001

00902 600011.SS Huaneng Power International, Inc. 21/01/1998 06/12/2001

00914 600585.SS Anhui Conch Cement Co. Ltd. 21/10/1997 07/02/2002

00921 000921.SZ Hisense Kelon Electrical Holdings Co. Ltd. 23/07/1996 13/07/1999

00939 601939.SS China Construction Bank Corporation 27/10/2005 25/09/2007

00991 601991.SS Datang International Power Generation Co., Ltd. 21/03/1997 20/12/2006

00995 600012.SS Anhui Expressway Co. Ltd. 13/11/1996 07/01/2003

00998 601998.SS China CITIC Bank Corporation Ltd. 27/04/2007 27/04/2007

01033 600871.SS Sinopec Yizheng Chemical Fibre Co. Ltd. 29/03/1994 11/04/1995

01053 601005.SS Chongqing Iron & Steel Co. Ltd. 17/10/1997 28/02/2007

01055 600029.SS China Southern Airlines Co. Ltd. 31/07/1997 25/07/2003

01065 600874.SS Tianjin Capital Environmental Protection Co. Ltd. 17/05/1994 30/06/1995

01071 600027.SS Huadian Power International Corporation Ltd. 30/06/1999 03/02/2005

01072 600875.SS Dongfang Electric Corporation Ltd. 06/06/1994 10/10/1995

01088 601088.SS China Shenhua Energy Co. Ltd. 15/06/2005 09/10/2007

01108 600876.SS Luoyang Glass Co. Ltd. 08/07/1994 31/10/1995

01138 600026.SS China Shipping Development Co. Ltd. 11/11/1994 23/05/2002

01171 600188.SS Yanzhou Coal Mining Co. Ltd. 01/04/1998 01/07/1998

01186 601186.SS China Railway Construction Corporation Ltd. 13/03/2008 10/03/2008

01398 601398.SS Industrial and Commercial Bank of China Ltd. 27/10/2006 27/10/2006

- 8 -

01898 601898.SS China Coal Energy Co. Ltd. 19/12/2006 01/02/2008

01919 601919.SS China COSCO Holdings Co. Ltd. 30/06/2005 26/06/2007

02318 601318.SS Ping An Insurance (Group) Co. of China Ltd. 24/06/2004 01/03/2007

02338 000338.SZ Weichai Power Co. Ltd. 11/03/2004 30/04/2007

02600 601600.SS Aluminum Corporation of China Ltd. 12/12/2001 30/04/2007

02628 601628.SS China Life Insurance Co. Ltd. 18/12/2003 09/01/2007

02866 601866.SS China Shipping Container Lines Co. Ltd. 16/06/2004 12/12/2007

02883 601808.SS China Oilfield Services Ltd. 20/11/2002 28/09/2007

03328 601328.SS Bank of Communications Co., Ltd. 23/06/2005 15/05/2007

03968 600036.SS China Merchants Bank Co., Ltd. 22/09/2006 09/04/2002

03988 601988.SS Bank of China Ltd. 01/06/2006 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 i’s A- and H-share’s 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:

- 9 -

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

2. positively related to VARHit = Var(rH,it)

where rA,it and rH,it are the return of firm i’s 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-share’s is employed in the hypothesis: TOit = (VOLA,it / TBA,it) / (VOLH,it / TBH,it),

where VOLA,it and VOLH,it are firm i’s A- and H-shares’ trading volume at time t and

- 11 -

TBA,it and TBH,it are firm i’s 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-share’s 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

- 12 -

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 i’s 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 +εit

- 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.

- 14 -

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.

- 15 -

Tab

le 4

: D

escr

ipti

ve

stat

isti

cs o

f var

iable

s (v

alues

are

cal

cula

ted o

n a

month

ly b

asis

)

Det

ail

Var

iable

M

athem

atic

al

repre

senta

tion

M

ean

M

edia

n

M

axim

um

M

inim

um

S

td. D

ev.

S

kew

nes

s C

oef

fici

ent

of

var

iati

on

Dis

count

DIS

it

(PA

,it –

PH

,it X

t)/

PA

,it

0.4

249

0.4

270

0.8

960

-0.2

109

0.2

371

-0.1

92

0.5

58

H-s

har

e re

turn

sensi

tivit

y

SH

Ait

Cov(r

A,i

t, r H

,it)

/ V

ar(P

A,i

t)

0.0

0616

0.0

0104

2.0

9819

-0.3

0823

0.0

5506

30.1

10

8.9

41

H-s

har

e re

turn

var

ian

ce

VA

RH

it

Var

(rH

,it)

0.0

0136

0.0

0079

0.0

3407

0.0

0001

0.0

0216

6.9

13

1.5

90

Mar

ket

cap

ital

izat

ion

(mil

lion)

SIZ

Eit

SIZ

Eit

97007.7

2

12653.3

0

3292984.0

0

493.6

0

289967.0

0

5.1

93

2.9

89

Rel

ativ

e tu

rnover

rat

e T

Oit

(VO

LA

,it /

TB

A,i

t) /

(VO

LH

,it /

TB

H,i

t)

6.4

712

3.3

013

167.7

929

0.1

029

11.2

702

6.2

40

1.7

42

Rel

ativ

e sp

read

S

PR

it

SP

RH

,it /

SP

RA

,it

1.0

289

0.9

221

8.4

687

0.0

125

0.5

805

2.5

77

0.5

64

Rel

ativ

e su

pply

of

shar

es

SU

Pit

T

BA

,it /

TB

H,i

t 0.5

518

0.3

547

3.3

431

0.0

280

0.4

813

2.1

98

0.8

72

Corr

elat

ion o

f H

-sh

are

retu

rn w

ith M

SC

I re

turn

D

IVM

SC

I,it

Corr

(rH

,it,

r MS

CI,

t)

0.1

772

0.1

807

0.9

982

-0.9

184

0.2

681

-0.1

698

1.5

135

Corr

elat

ion o

f H

-sh

are

retu

rn w

ith H

SI

retu

rn

DIV

HS

I,it

Corr

(rH

,it,

r HS

I,t)

0.4

335

0.4

672

0.9

848

-0.8

980

0.2

960

-0.7

537

0.6

829

- 16 -

Table 5: Pairwise correlation

DISit SHAit VARHit SPR it TOit DIVmsci,it SIZEit SUPit DIVhsi,it

DISit 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 0.127 0.254 1.000 0.102 -0.022 0.095 -0.022 0.034 0.131

SPR it 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 -0.113 -0.059 0.095 -0.035 -0.008 1.000 0.133 -0.013 0.474

SIZEit -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

- 17 -

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 -

Tab

le 6

: R

egre

ssio

n r

esult

(cr

oss

sec

tional

model

, m

onth

ly d

ata,

sam

ple

siz

e:1893)

(model

corr

ecte

d b

y N

ewey

-Wes

t H

eter

osk

edas

tici

ty a

nd A

uto

corr

elat

ion C

onsi

sten

t C

ovar

iance

Mat

rix

Est

imat

ion)

Factors/M

odel

Expected sign

1

2

3

4

5

6

7

Const

ant

term

0.4

028

0.4

180

0.4

031

0.3

627

0.3

444

0.3

250

0.4

059

(15.6

9**)

(15.0

2**)

(15.7

4**)

(16.5

5**)

(16.3

8**)

(15.2

1**)

(26.5

9**)

Inform

ation asymmetry

SH

Ait

- 0.0

3545

0.0

4415

(0.4

4)

(0.5

7)

VA

RH

it

+

13.6

769

13.9

419

13.9

195

13.3

706

13.8

937

12.5

975

13.9

635

(4.4

7**)

(4.3

8**)

(4.8

9**)

(4.7

8**)

(4.9

4**)

(4.5

3**)

(4.8

8**)

Liquidity

TO

it

+

0.0

02755

0.0

02581

0.0

0276

0.0

02737

0.0

02899

0.0

02935

(4.3

2**)

(4.1

4**)

(4.3

3**)

(4.2

7**)

(4.3

6**)

(4.3

8**)

SP

R i

t +

0.0

49192

0.0

50777

0.0

49044

0.0

53556

0.0

59653

0.0

61959

(4.2

1**)

(4.3

3**)

(4.2

2**)

(4.5

2**)

(4.9

8**)

(5.1

1**)

Diversification

DIV

msc

i,it

+

-0.0

8342

-0

.08403

-0.0

8429

-0.1

0483

(-3.8

3**)

(-

3.8

9**)

(-3.9

0**)

(-4.7

9**)

DIV

hsi

,it

+

-0

.07428

(-

3.0

2**)

Market Capitalization

- 19 -

SIZ

Eit

- -0

.00000016

-0.0

0000015

-0.0

0000016

-0.0

0000014

(-3.6

0**)

(-3.2

6**)

(-3.6

1**)

(-3.4

3**)

Supply of shares

SU

Pit

- -0

.06312

-0.0

6291

-0.0

6331

(-2.7

3**)

(-2.6

8**)

(-2.7

4**)

Adj

R2

10.7

0%

10.6

0%

10.7

4%

9.2

0%

6.2

5%

4.9

1%

1.5

7%

- 20 -

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 people’s 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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