There are many studies that have focused on the relationship between market segmentation and stock prices in emerging markets. For instance, Domowitz, Glen, and Madhavan (1997) examined the relationship induced by ownership restrictions in
Mexico. The restrictions on equity ownership in Mexico and China are very much alike because in both countries there are multiple classes of stock shares that differentiate between domestic and foreign investors. Significant stock price premiums are documented for unrestricted shares that have only been opened to foreign investors and in their study they argue that the stock price premium reflects the relative scarcity of unrestricted shares. In other stock markets with partial segmentation between domestic and foreign investors through dual classes of shares, the foreign class shares are generally sold at a premium, but in China the B-shares are generally traded at a discount.3 Chakravarty, Sarkar, and Wu (1998) have thus tried to explain the sources of different kinds of price behavior for the A-shares and the B-shares and have argued that the price discount results from the information asymmetry between foreign investors and domestic investors. Foreign investors are less able to acquire and assess information regarding China’s companies, relative to domestic investors, due to language barriers, different accounting standards, and a lack of reliable information about the economy and companies in China.
On the other hand, Chui and Kwok (1998) pointed out that foreign investors receive news about China faster than domestic investors because of the information barriers within China. The rational investors that buy and sell A-shares should make trading decisions based on the previous price movements of the B-shares. As a result, the returns on the B-shares lead the returns on the A-shares. However, Chen, Lee, and Rui (2001) did not support this information hypothesis because their empirical results showed that there is no casual relationship between the returns (volatility) in relation to the A-shares and the returns (volatility) in relation to the B-shares during the sample period from 1992 to 1997.
3 For example, Loderer and Jacobs (1995) found that Nestle’s foreign-held voting bearer stocks were selling for about twice the price of the domestically-held registered shares when, on November 17, 1998, Nestle’s board decided to allow foreign investors to hold registered shares.
The liquidity hypothesis provides another explanation for the price discounts related to the B-shares. According to this hypothesis, the price discounts are caused by the B-shares’ lower liquidity and higher transaction costs. Amihud and Mendelson (1986) noted that illiquid stocks should have higher expected returns and should be priced lower to compensate investors for the increased trading costs. Chen, Lee, and Rui (2001) supported this hypothesis with their panel data analysis results, which showed that the significant price discounts were primarily due to the illiquidity of the B-share market.
The differential risk hypothesis also provides an explanation for the price discounts related to the B-shares. This hypothesis argues that domestic investors and foreign investors have different degrees of risk aversion because the domestic stock market is highly speculative. The speculative behavior of Chinese investors may push up the prices of A-shares. If this hypothesis were true, there ought to be a positive relationship between the price discounts and this risk level. However, Chen, Lee, and Rui (2001), who used the variance of returns as a proxy for the risk level, did not support this hypothesis.
In addition to the studies on the differences in price behavior between the A-share market and the B-share market, the volatility of China’s stock market is also an important issue for academics and investors. Su and Fleisher (1998) argued that the volatility of China’s stock market returns is high relative to developed markets.
From their empirical results, they argued that the variance of stock market excess returns is time-varying, mildly persistent and is influenced by government market support and liberalization policies. They also found that volatility decreased after the announcement of market liberalization policies in July 1994 and that the volatility of the A-share market and the B-share market were different. Since the A-shares and the B-shares have the same ownership rights and claims to future cash flows, the
sources of the differences in volatility across China’s stock markets have become an interesting issue. Su and Fleisher (1999) stated that the differences in volatility between the A-shares and the B-shares were related to the differences in the intensity of news announcements and the differences in the way that such news is incorporated into trading decisions. Besides that, they found that there exists a positive relationship between the time-series of the price discounts and the differences in the volatility-related expected intensity of information flows.
He, Wu, and Chen (2002) tried to find another explanation for the disparity in the volatility of the A-shares and the B-shares. The microstructure theory developed by Kyle (1985) and Easley, Kiefer, O’Hara, and Paperman (1996) suggests that volatility is related to asymmetric information. According to this theory, higher volatility is caused by a higher degree of information asymmetry and increased participation on the part of informed traders in the market, which in turn lead to higher trading costs.
The empirical results of He, Wu, and Chen (2002) indicated that the higher volatility of the B-shares is attributable to the higher market-making costs faced by foreign investors and they argued that the volatility disparity between the two markets will disappear when controlling for informed trading and other trading costs.
Earlier studies treated the A-share market and the B-share market as two segmented markets because of the investment restrictions in China. After the market liberalization policies were implemented, the two markets were able to interact with each other more frequently and to impact the two markets. Henry (2000) argued that the equity price indexes of emerging countries experienced abnormal returns before the implementation of the initial stock market liberalization. His results supported the prediction of the international asset-pricing model that market liberalization policies may reduce the country’s cost of equity by sharing risk between the domestic and foreign investors. Chiu, Lee, and Chen (2005) investigated the impact of the
opening of the B-share market on local Chinese with foreign-currency accounts.
Their empirical results showed that, after allowing domestic investors to invest in the B-share market, the volatility transmission process had speeded up and the persistence of the impact had been shortened. They argued that the market liberalization impacted not only the A-share market but also the B-share market.