Because the data about the QFII ratios are collected weekly in Taiwan, we regress the DR returns of the Taiwanese firms on one more variable, "QFII own-ership ratio change," in eqs. (8) and (9) for cointegrated pairs and eqs. (10) and
(11) for noncointegrated pairs. Table 6 shows the results of the DR price dynamics with this variable. Changes in the QFII ownership ratio significantly affect current DR returns for 23 of the 29 Taiwanese firms. The average coefficients of changes in the QFII ownership ratio in Table 7 are 0.05067 and 0.04533 for cointegrated pairs and noncointegrated pairs respectively, significantly different from zero at the
1 percent level.
To examine the incremental explanatory power of the QFII variable, we use the LR and partial F statistics tests. These results are presented in Table 7. The LR statistics and partial F statistics reject the hypotheses that K = 0 and p = 0 for 23 of the 29 firms. The change in the QFII ownership ratio significantly and additionally explains the variations of DR returns.
The changes of the QFII ownership ratios contain incremental information content regarding DRs in the VAR and VECM models, but not in the SUR model.
Actually, investors can predict current DR returns with historical time-series DR and underlying security returns; current DR returns can be explained by past values of DRs and underlying securities. The VAR and VECM models investigate whether adding QFII ownership ratios improves the explanation. These models capture the incremental information content of foreigners' demand on current DR returns con-ditional on the past price information of DRs and underlying securities.
The current DR returns are explained by current underlying security returns in the SUR model. Actually, the current underlying security returns contain a large set of complicated information. The components of the current underlying security returns include foreigners' capital inflows, the lagged performance of DRs or un-derlying securities, and the local or global risk factors. SUR models cannot capture the foreigners' demand effect on current DR returns precisely. Current QFII own-ership ratio changes therefore provide an additional explanation for the current DR returns in the VAR and VECM models, but not in SUR models. Hence, the results of QFII ownership ratio changes are sensitive to the specification of the model.
For the same reason, the VAR and VECM results support the effect of the lagged DR and underiying security prices on current DRs, while the SUR results do not. In VECM models, the price relationship between lagged DR and underlying security prices adjust current DR returns. In VAR models, the lagged DR and underlying security returns are significantly associated with current DR returns.
However, the current underlying security contains the effect of historical infor-mation about the DRs returns, underlying security returns, and changes in the QFII ownership ratio. The SUR model cannot investigate the DR price dynamics exactly.
In summary, the QFII ownership ratio changes, returns on the local market index, and the historical information about the DRs and underlying securities are signif-icantly related to the current DR returns in VECM or VAR models, but not in SUR models.
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TABLE 7
Results on the Incremental Information Content of Changes in the QFII Ownership Ratio
"The names of firms are available from the authors.
*Significatit at the 10 percent level.
**Significant at the 5 percent level.
***Significant at the 1 percent level.
6. Conclusion
We studied the price dynamics of depositary receipts issued by Taiwanese and Hong Kong firms and considered the implications of the differing regulatory en-vironments of these two areas. Hong Kong is a completely free-entry market, while the Taiwanese market is regulated, with restrictions on foreign ownership. The difference in regulations enabled us to address the economic consequences of
cap-TAIWAN AND HONG KONG MARKETS 327 ital controls. With the admission of Taiwan into WTO in the near future, the results of this study will be relevant to private investment decisions as well as public policies.
We initially examined the interrelationships between the DR and underlying security prices by employing different models. For firms in the free-entry Hong Kong market, investors with underlying securities (DRs) are allowed to convert into the DRs (underlying securities). Our results indicate an average 0.7 percent DR price discount, which supports the law of one price. We found that long-term equilibrium relationships between DR and underlying security prices exist for all the Hong Kong firms, but Taiwanese firms show long-term price premiums. This result implies a regulatory impact on the price divergence between DR and under-lying security prices.
Specifically, we used the VECM and VAR models to study the DR price dynamics. For Hong Kong and Taiwanese firms with cointegrated pairs, the dif-ference in DR and underlying security prices is a short-term phenomenon. In the short run, if DR prices are too high (low) in comparison with the corresponding original market prices, they finally adjust down (up) toward the long-run equilib-rium. The relationships between depositary receipts and underlying securities are the most important factor in explaining the prices of the depositary receipts. The price deviations between DRs and underlying securities, captured by the error cor-rection terms, negatively affect the DR returns in a larger magnitude for Hong Kong firms than for Taiwan firms. This implies that information transmits and price adjusts more quickly in free-entry markets. For Taiwanese firms with noncointe-grated pairs in the VAR model, the lagged performance of the DRs and underlying securities becomes important in the absence of a long-term equilibrium.
We also found that the value of the local market index (the market where the underlying securities are listed) is refiected in depositary receipt prices, so investors may incorporate this information when forming their investment strategy. We did not find robust evidence that global risk factors explain DR returns.
More interestingly, in the VAR and VECM models, our empirical results in-dicate that the QFII ownership ratio change, the overseas investor demand proxy, positively and incrementally explains the DR prices. This implies that the "QFII ownership ratio" has incremental information content for DR prices for firms listed in areas with restrictions on foreign ownership.
Although we found a persistent DR price premium for Taiwanese firms, we did not provide a precise examination of DR premiums. This is an interesting question for future research. In addition, in Taiwan, with foreign ownership restric-tions, DRs can be converted back to underlying securities directly, so DRs traded at a discount should eventually be converted back into underlying securities. The DR discount may exist for only a period of time, and then the outstanding DRs in foreign market will flow back to the home market until the price discount is elim-inated. Since our research does not examine the "fiowback effect" explicitly, ad-ditional studies are required to examine the correlation between the DR discount and DR outstanding shares to confirm its existence and importance.
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