Encyclopedia of Finance Part 9 ppsx

It is found that B-share mar-ket has persistent higher bid-ask spreads than the A-share market and traders in the B-share market bear higher informed trading and other transaction costs.

CHINESE A AND B SHARES

YAN HE, Indiana University Southeast, USA

Abstract

A and B shares exist in the Chinese stock markets

A shareholders are domestic investors and B

share-holders are foreign investors During the early-and

mid-1990s, B shares were traded at a discount

rela-tive to A shares, and B-share returns were higher

than A-share returns It is found that B-share

mar-ket has persistent higher bid-ask spreads than the

A-share market and traders in the B-share market

bear higher informed trading and other transaction

costs In addition, the higher volatility of B-share

returns can be attributed to the higher market

mak-ing costs in the B-share market

Keywords: Chinese A shares; Chinese B shares;

stock; return; volatility; asymmetric information;

bid-ask spread; transaction costs; stock ownership;

Shanghai stock exchange; Shenzhen stock

ex-change

The development of equity markets in China

started in early 1990s Open for business in

Decem-ber 1990, the Shanghai Stock Exchange (SHSE)

and the Shenzhen Stock Exchange (SZSE) are the

two major securities exchanges in China By 1998,

the SHSE had raised a total of RMB140.814

bil-lion for listed companies and the SZSE had raised

a total of RMB 128 billion for listed companies

The two exchanges played an important role in

promoting the restructuring of state-owned

enter-prises

Stock shares in China are divided into two broad categories: untradable and tradable By the end of 1998, the total untradable equity of the listed companies was 166.484 billion shares (i.e 65.89 percent of the total equity of the listed companies), allocated as follows: (1) shares owned

by government, 86.551 billion; (2) shares owned by legal persons, 71.617 billion; (3) shares owned

by employees and others, 8.317 billion Outstand-ing tradable shares totaled 86.193 billion shares (i.e 34.11 percent of the total equity of the listed companies), allocated as follows: (1) Class A shares, 60.803 billion; (2) Class B shares, 13.395 billion; and (3) Class H shares, 11.995 billion Class A shares are owned by domestic investors and traded in the domestic markets Class B shares are owned by foreign investors but traded in the domestic markets Class H shares are listed on the Hong Kong Stock Exchange

China has tightly restricted foreign stock own-ership throughout the 1990s The ownown-ership re-striction creates two distinct groups of investors: the domestic and foreign investors Class A shares are domestic shares and class B shares are foreign shares In 1991, the Shanghai Stock Exchange (SHSE) and Shenzhen Stock Exchange (SZSE) began to offer B shares, providing foreign investors with a legal channel to invest in China’s equity markets B shares are also known as Renminbi Special Shares B shares are issued in the form of registered shares and they carry a face value de-nominated in Renminbi B shares are subscribed

and traded in foreign currencies, but they are

listed and traded in securities exchanges inside

China The B share market has attracted a

consid-erable amount of foreign investors The Market

provides an additional channel for foreign capital

to invest in China

Since March 2001, China has opened its B-share

market – previously reserved for overseas investors –

to Chinese individuals with foreign currency

de-posits However, the impact of the opening up of

the B-share market to Chinese is limited, because

that market is small compared to the number of

Chinese people and institutions’ foreign currency

holdings Despite the rising foreign currency

de-posits in China, Chinese people who have foreign

currency holdings still account for a very small

proportion of investors

Tables 15.1 to 15.3 are obtained from the China

Securities Regulatory Committee

During the early- and mid-1990s, B shares were

traded at a discount relative to A shares, and

B-share returns were higher than A-share returns

Su (1999) explains the return premiums on the

foreign-owned B shares in the Chinese stock

mar-kets by testing a one-period capital asset-price

model (CAPM) He concludes that foreign

inves-tors are more risk-averse than domestic invesinves-tors Sun and Tong (2000) explain the price discount of the B shares by differential demand elasticity They document that when more H shares and red chips are listed in Hong Kong, the B-share discount becomes larger In addition, Chui and Kwok (1998) show that the returns on B shares lead the returns on A shares, which induces an asymmetric positive cross-autocorrelation between the returns

on B and A shares They argue that A- and B-share investors have different access to information, and information often reaches the B-share market be-fore it reaches the A-share market

The Chinese stock markets have grown very rapidly during the late 1990s and early 2000s

A number of studies investigate the return and risk in the newly developed markets For example, Lee et al (2001) examine time-series features of stock returns and volatility, as well as the relation between return and volatility in four of China’s stock exchanges On the one hand, test results provide strong evidence of time-varying volatility and show volatility is highly persistent and predict-able On the other hand, the results do not show any relation between expected returns and expected risk

Table 15.1 Trading summary of A and B shares during 11=2000–11=2001

A or B share

listed

Total market capitalization

Stock turnover

Stock trading volume

No of transactions

No of companies (100 000 000 Yuan) (100 000 000 Yuan) (100 000 000) (10 000)

436 ENCYCLOPEDIA OF FINANCE

The development in the Chinese markets may

affect the risk and return of A- and B-share classes

He and Wu (2003) provide two interesting

find-ings: (1) the daily returns of domestic shares (A

shares) and foreign shares (B shares) were almost

identical in the late 1990s, while the B-share

re-turns were much higher than the A-share rere-turns

during the mid-1990s; (2) the volatility of B-share

daily returns was higher than that of A shares,

while previous studies have often documented

higher return volatility for A shares (For example,

Su and Fleisher (1999) report that A shares have

higher volatility than B shares based on the data of

mid-1990s.)

Since A and B shares are entitled to the same

cash flows of a firm and have similar returns, the

higher return volatility of B shares is puzzling The

market microstructure theory suggests that both

volatility and bid-ask spreads are positively related

to asymmetric information (see Kyle, 1985; Easley

et al., 1996) According to this theory, higher

vola-tility is caused by higher degree of information

asymmetry and participation rate of informed traders in the market, which, in turn, lead to higher trading costs Thus, the higher volatility of B shares may be due to a more severe asymmetric information problem in the B-share market If so,

we should observe higher trading costs for B shares Furthermore, Easley et al (1996) show that spreads and volatility are negatively related

to liquidity Since the order processing cost is the cost of providing liquidity and immediacy, lower liquidity results in higher order processing cost and higher volatility A recent study by Green

et al (2000) on the London Stock Exchange shows that changes in transaction costs have a significant effect on share price volatility More-over, Chordia et al (2002) document that return volatility is significantly related to quoted spreads These findings confirm the theoretical prediction that volatility and trading costs are positively correlated

Therefore, the higher volatility in the B-share market may reflect higher idiosyncratic risk (rather

Table 15.2 A and B shares offering (1987–1998)

Capital raised (RMB 100MM) 10 25 7 4 94 375 327 150 425 1,294 837 3,553

Table 15.3 Number of listed companies (1990–1998)

than higher systematic risk) of B-share stocks The

trading risk associated with asymmetric

informa-tion can be diversified away and therefore it is not

systematic risk (see Chordia et al 2001)

Asset-pricing models (e.g CAPM and APT) suggest

that expected returns should be determined by

systematic risk Since higher volatility does not

necessarily imply higher systematic risk, it may

not be accompanied with higher returns Su

(1999) finds that market risk (measured by market

betas) can explain returns of A and B shares, but

nonmarket risk variables, such as the variance of

returns and firm size, do not systematically

affect returns Thus, the difference in return

vola-tility between the A- and B-share markets may be

caused by the difference in idiosyncratic risk

Trad-ing cost, which reflects asymmetric information

and liquidity of trading, may explain the B-share

market anomaly For example, if B-share investors

incur higher trading costs than A-share investors,

the return volatility of B shares would be higher

than that of A shares, other things being equal In

line with the above arguments, He and Wu (2003)

examine whether the difference in trading costs (or

market making costs) between the Chinese A and

B shares can explain the difference in return

vola-tility between the two classes of shares They

esti-mate the end-of-day bid-ask spread and its

informed trading and noninformed trading cost

components for each stock using daily data in the

late 1990s Their results show that the B-share

market has persistent higher bid-ask spreads than

the A-share market, and traders in the B-share

market bear higher informed trading and other

transaction costs Furthermore, they find that the

higher volatility of B-share returns can be

attrib-uted to the higher market making costs in the B-share market

REFERENCES Chordia, T., Roll, R., and Subrahmanyam, A (2002).

‘‘Order imbalance, liquidity, and market returns.’’ Journal of Financial Economics, 65: 111–131 Chui, A and Kwok, C (1998) ‘‘Cross-autocorrelation between A shares and B shares in the Chinese Stock Market.’’ Journal of Financial Research, 21: 333–354.

Easley, D., Kiefer, N., O’Hara, M., and Paperman,

J (1996) ‘‘Liquidity, information, and infrequently traded stocks.’’ Journal of Finance, 51: 1405–1436 Green, C.J., Maggioni, P., and Murinde, V (2000).

‘‘Regulatory lessons for emerging stock markets from a century of evidence on transactions costs and share price volatility in the London Stock Exchange.’’ Journal of Banking and Finance, 24: 577–601.

He, Y., Wu, C., and Chen, Y.-M (2003) ‘‘An explan-ation of the volatility disparity between the domestic and foreign shares in the Chinese Stock Markets.’’ International Review of Economics and Finance, 12: 171–186.

Kyle, A (1985) ‘‘Continuous auctions and insider trad-ing.’’ Econometrica, 53: 1315–1335.

Lee, C.F., Chen, G., and Rui, O.M (2001) ‘‘Stock returns and volatility on China’s stock markets.’’ The Journal of Financial Research, 24: 523–544.

Su, D (1999) ‘‘Ownership restrictions and stock prices: evidence from Chinese markets.’’ Financial Review, 34: 37–56.

Su, D and Fleisher, B.M (1999) ‘‘Why does return volatility differ in Chinese stock markets?’’ Pacific-Basin Finance Journal, 7: 557–586.

Sun, Q and Tong, W (2000) ‘‘The effect of market segmentation on stock prices: the China syndrome.’’ Journal of Banking and Finance, 24: 1875–1902.

438 ENCYCLOPEDIA OF FINANCE

DECIMAL TRADING IN THE

U.S STOCK MARKETS

YAN HE, Indiana University Southeast, USA

Abstract

All NYSE-listed stocks were switched from a

frac-tional to a decimal trading system on January 29,

2001 and all NASDAQ stocks followed suit on April

9, 2001 The conversion to decimal trading in the

U.S markets has significantly reduced bid–ask

spreads This decline is primarily due to the drop in

market makers’ costs for supplying liquidity In

add-ition, rounding becomes less salient after the

deci-malization The decrease in bid–ask spreads can be

ascribed to the decrease in price rounding, when

controlling for the changes in trading variables

Keywords:decimal trading; decimalization; NYSE;

NASDAQ; clustering; rounding; bid–ask spread;

volatility; fractional trading; price improvement

The minimum increment of trading prices varies

substantially with market and location For

in-stance, pricing of stock, bond, and options markets

in the U.S and Canada had traditionally been

denominated in eighths, while in European and

Asian markets decimal prices are more common

During the later half of 1990s, the U.S and

Can-adian markets underwent substantial changes

Canadian stocks switched from fractions to

deci-mals in April 1996 In the U.S markets, the

min-imum tick size was reduced from one-eighth of a

dollar to one-sixteenth of a dollar in June 1997 At

the beginning of year 2000, the U.S equity markets

were the only major financial markets in the world that traded in fractional increments This frac-tional trading practice puts U.S markets at a com-petitive disadvantage with foreign markets trading the same securities In addition, individual inves-tors may have a difficulty in determining the dif-ferences between increasingly smaller fractions

To make the U.S securities markets more com-petitive globally and their prices easier to decipher, the Securities Industry Association and the Secur-ities and Exchange Commission decided to convert the U.S equity and exchange-traded options mar-kets from fractional to decimal trading The NYSE selected seven pilot securities for a decimal pricing test on August 28, 2000, another 57 securities were added to the pilot program on September 25, 2000, and another 94 were added on December 4, 2000 The NASDAQ market began its decimal test with

14 securities on March 12, 2001, and another 197 securities were added on March 26, 2001 All NYSE-listed stocks were switched to a decimal trading system on January 29, 2001 and all NAS-DAQ stocks followed suit on April 9, 2001 Recently, a number of studies have generated interesting findings about the effects of decimaliza-tion on return volatility and bid–ask spreads They report that decimalization affects bid–ask spreads, volatility, quote size, and price improvement frequency (or the probability of trades within the quoted bid–ask spreads) First of all, it was shown that the recent conversion to decimal trading in the

U.S markets has significantly reduced bid–ask

spreads (see NYSE, 2001; NASDAQ, 2001;

Chak-ravarty et al., 2001a,b; Chung et al., 2001; Gibson

et al., 2002) These findings coincide with two

earl-ier studies (Ahn et al., 1998; Bacidore, 1997) on the

Toronto Stock Exchange (TSE) Bacidore et al.,

(2001b) examine a wide range of market quality

issues on the NYSE post-decimalization, and find

that an increase in the aggressiveness of limit order

pricing results in narrower bid–ask spreads Chung

et al (2004) examine the relationship between

NASDAQ trading costs and the extent of order

preferencing They document lower order

prefer-encing and a positive relationship between the bid–

ask spread and the proportion of internalized

vol-ume on NASDAQ after decimalization Second,

Bessembinder (2003) and NASDAQ (2001) show

that intraday return volatility has declined, and

there is no evidence of systematic reversals in

quotation changes Thus, it appears that the

NYSE and NASDAQ markets are able to supply

sufficient liquidity in the wake of decimalization

Third, Bessembinder (2003) presents that quote

size decreases after decimalization Jones and

Lip-son (2001) and Goldstein and Kavajecz (2000)

re-port decreases in limit-order book depth after an

earlier NYSE tick size reduction, and Bacidore

et al (2001a) report decreases in limit-order book

depth after the decimalization on the NYSE

Fi-nally, Bacidore et al (2001b) and Bessembinder

(2003) find evidence that the percentage of orders

experiencing price improvement (i.e executed

within the quotes) increases on the NYSE after

decimalization, though the dollar amount of price

improvement falls According to Coughenour and

Harris (2003), decimal trading effectively relaxes

the public order precedence rule and gives

special-ists more price points within the bid–ask spread

on which to quote aggressively This allows

spe-cialist trading firms of all size to trade more

often inside the current quote and so the

probabil-ity that a trade occurs inside the quotes becomes

higher

Almost all the above studies document the

changes in ‘‘total’’ return volatility and spreads of

transactions He and Wu (2004) examine the composition of return volatility, serial correlation, and trading costs before and after the decimaliza-tion on the NYSE Specifically, they decompose the variance of price changes into components associated with public news, rounding errors, and market-making frictions (asymmetric information and liquidity costs) First, the test results show that both variance components due to market-making frictions (or bid–ask spreads) and rounding errors decline considerably after decimalization, while the variance component due to public news shocks remains unchanged Second, the serial correlation

of price changes is significantly reduced after deci-malization, indicating a weakened bid–ask bounce effect as a result of decimal trading Finally, bid– ask spreads decline substantially after decimaliza-tion and this decline is primarily due to the drop in market makers’ costs for supplying liquidity

In addition to volatility and transaction costs, the recent decimalization also provides an oppor-tunity to revisit the issue of price rounding Since traders often choose to use a larger price increment than the minimum tick, prices tend to cluster on certain fractions or decimals even when the tick is small (See Ball et al (1985) for gold trading; Brown et al (1991) for silver; Goodhart and Cur-cio (1992) for foreign exchange; and Aitken, et al (1995) for Australian stocks.) Harris (1999) pre-dicts that the conversion to decimal trading would lead to lower execution costs Bessembinder (2002) shows that bid–ask spreads have declined after the decimalization

He and Wu (2003) investigate the pattern of price rounding before and after decimal trading and its effect on bid–ask spreads for NYSE stocks

by using the second pilot sample which includes 57 NYSE securities Prior to September 25, 2000, these stocks were traded on sixteenths Since then, they have been traded on pennies First, since decimal trading leads to a finer price grid or

a set of less discrete prices, it is expected to observe

a decline in frequencies of rounding on integers, halves, and quarters Second, although frequencies

of rounding on integers, halves, and quarters may

440 ENCYCLOPEDIA OF FINANCE

decline after decimalization, it is expected that

cross-sectionally the relationship between

round-ing and tradround-ing variables and the relationship

be-tween execution costs and rounding will stay the

same That is, the sensitivity of trading variables

to rounding and the sensitivity of execution costs to

rounding should remain unchanged because the

fundamentals of the market do not change as a

result of decimalization Finally, consistent with

the arguments of Harris (1997, 1999), it is expected

to find a significant relationship between the

de-crease in execution costs and the dede-crease in

rounding after decimalization, when controlling

for the changes in stock features If fractional

pri-cing indeed allows market makers to keep bid–ask

spreads artificially high to earn a positive rent, a

conversion to decimal trading should reduce price

rounding, decrease market makers’ rents, and

cause a fall in bid–ask spreads

The empirical results of He and Wu (2003)

show that although rounding is pervasive in

trans-action prices, bids, and asks in both the pre- and

post-decimalization periods, it has become less

sa-lient after the decimalization The cross-sectional

relationship between rounding and trading

vari-ables is similar before and after the decimalization,

and so is the relationship between execution costs

and rounding when trading variables are held

con-stant for each stock More importantly, the quoted

and effective bid–ask spreads decrease after the

decimalization, and this decrease can be ascribed

to the decrease in price rounding when controlling

for the changes in trading variables

REFERENCES Ahn, H.-J., Cao, Q.C., and Choe, H (1998)

‘‘Decimal-ization and competition among stock markets:

Evidence from the Toronto stock exchange

cross-listed securities.’’ Journal of Financial Markets, 1:

51–87.

Aitken, M., Brown, P., Buckland, C., Izan, H.Y., and

Walter, T (1995) ‘‘Price clustering on the Australian

stock exchange.’’ Working Paper, University of

Western Australia.

Bacidore, J (1997) ‘‘The impact of decimalization on market quality: an empirical investigation of the To-ronto Stock Exchange.’’ Journal of Financial Inter-mediation, 6: 92–120.

Bacidore, J., Battalio, R., and Jennings, R (2001a).

‘‘Order submission strategies, liquidity supply, and trading in pennies on the New York Stock Ex-change,’’ Working Paper, Indiana University Bacidore, J., Battalio, R., Jennings, R., and Farkas, S (2001b) ‘‘Changes in order characteristics, displayed liquidity, and execution quality on the NYSE around the switch to decimal pricing,’’ Working Paper, The New York Stock Exchange.

Ball, C.A., Torous, W.N., and Tshoegl, A.E (1985).

‘‘The degree of price resolution: the case of the gold market.’’ Journal of Futures Markets, 5: 29–43 Bessembinder, H (2003) ‘‘Trade execution costs and market quality after decimalization.’’ Journal of Fi-nancial and Quantitative Analysis, 13: 19–42.

Brown, S., Laux, P., and Schachter, B (1991) ‘‘On the existence of an optimal tick size.’’ Review of Futures Markets, 10: 50–72.

Chakravarty, S., Harris, S., and Wood, R (2001a).

‘‘Decimal trading and market impact,’’ Working Paper, University of Memphis.

Chakravarty, S., Harris, S., and Wood, R (2001b).

‘‘Decimal trading and market impact: The Nasdaq experience.’’ Working Paper, University of Memphis Chung, K., Van-Ness, B., and Van-Ness, R (2001).

‘‘Are Nasdaq stocks more costly to trade than NYSE stocks? Evidence after decimalization.’’ Working Paper, Kansas State University.

Chung, K., Chuwonganant, C., and McCormick, T (2004) ‘‘Order preferencing and market quality on Nasdaq before and after decimalization.’’ Journal of Financial Economics, 71: 581–612.

Coughenour, J and Harris, L (2003) ‘‘Specialist profits and the minimum price increment.’’ Working Paper Gibson, S., Singh, R., and Yerramilli, V (2002) ‘‘The effect of decimalization on the components of the bid-ask spreads.’’ Working Paper, Cornell University Goldstein, M and Kavajecz, K (2000) ‘‘Eighths, six-teenths and market depth: Changes in tick size and liquidity provision on the NYSE.’’ Journal of Finan-cial Economics, 56: 125–149.

Goodhart, C and Curcio, R (1992) ‘‘Asset price dis-covery and price clustering in the foreign ex-change market.’’ Working Paper, London School

of Business.

Harris, L (1997) ‘‘Decimalization: a review of the ar-guments and evidence.’’ Working Paper, University

of Southern California.

Harris, L (1999) ‘‘Trading in pennies: A survey of

the issues.’’ Working Paper, University of Southern

California.

He, Y and Wu, C (2003) ‘‘The effects of

decimaliza-tion on return volatility components, serial

correl-ation, and trading costs.’’ Working Paper.

He, Y and C Wu (2004) ‘‘Price rounding and bid-ask

spreads before and after the decimalization.’’

Inter-national Review of Economics and Finance, 13:

19–42.

Jones, C and Lipson, M (2001) ‘‘Sixteenths: direct evidence on institutional trading costs.’’ Journal of Financial Economics, 59: 253–278.

NASDAQ (2001) ‘‘The impact of decimalization on the NASDAQ stock market,’’ prepared by NAS-DAQ Research Department.

NYSE (2001) ‘‘Comparing bid-ask spreads on the NYSE and NASDAQ immediately following NAS-DAQ decimalization,’’ prepared by NYSE Research Department.

442 ENCYCLOPEDIA OF FINANCE