SHI YUAN CHEN *
SUBMITTED TO THE DEPARTMENT OF ECONOMICS OF AMHERST COLLEGE
IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF
BACHELOR OF ARTS WITH HONORS
PROFESSOR STEVEN RIVKIN, FACULTY ADVISOR
MAY 8, 2008
*Undergraduate student, Amherst College, Amherst, MA 01002.
Tel: (504)905-7341. E-mail: schen08@amherst.edu
ABSTRACT
This thesis investigates the impact of two separate events on the Hong Kong Stock Exchange (HKEX): the opening of the stock options market in Hong Kong in 1995 and the announcement that the exchange would be open to mainland Chinese investors in 2007. In the first case, the Hang-Seng Index is tested for evidence refuting random walk hypothesis using the Geary run test. This test was run on 8-year periods before and after the opening of the options market. The run test detected evidence of serial dependence which can be interpreted as the market being predictable or inefficient. In the second case, I examine the price relationship between shares of Chinese companies traded on both the Hong Kong stock exchange and the New York stock exchange. Using recent daily data from 2003 through 2008 across fourteen companies, I first checked to see if the stock price time series were stationary by running the Dickey Fuller test. The stock prices were found to be non-stationary, but the first differences of the stock prices or return series were stationary. This evidence of co-integration allowed a Granger causality test to be run on the return prices of two stocks. I found that price discovery existed between HKEX and NYSE as one would expect. I subsequently tested for whether or not there were any persistent price disparities between US ADRs and Hong Kong H- shares shortly after the announcement was made. I found that although all of the stocks experienced a price increase of 10% to 30% during the week of the announcement, there were no arbitrage opportunities between the US and Hong Kong markets.
Keywords: Information and Market Efficiency; Hong Kong Stock Exchange; Adaptive Markets Hypothesis
INTRODUCTION
The famous American economist James Tobin once stated that the most important implication of the efficient markets hypothesis is the channeling of investment to the most efficient users of capital (Tobin, 1982). Under this generally accepted framework, inefficiency in the stock market results in poor business investment decisions, imparting a real cost onto the economy. In the past thirty years, the consensus among economists has been that stock prices follow a random walk process and that the stock market is semi- strongly efficient under the efficient markets hypothesis proposed by Eugene Fama (Fama, 1970). Recently however, a study has found evidence of weekly returns of the US stock market rejecting the random walk hypothesis (Lo and MacKinlay, 1988). The focus of this paper is to survey the price behavior and efficiency of the Hong Kong stock exchange in response to important events.
The Hong Kong stock market has developed rapidly since its establishment in the late 1800s. It has always played a large role in facilitating trade between China and the rest of the world, and this continues to be true in the capital markets today. It is currently the third largest stock market in Asia and the sixth largest in the world. For more than a decade, Hong Kong has been recognized for closely following free-market principles; the Wall Street Journal gave Hong Kong the title of World’s Freest Economy for the 13th consecutive year based on a ranking system that considers several factors such as trade freedom, investment freedom, financial freedom, and property rights.
The two events this paper looks at are the launch of the Hong Kong stock options market on September 8th, 1995 and China’s announcement on August 20th, 2007 that the Hong Kong stock market would finally become accessible to the millions of investors in mainland China. The opening of the options market in the Hong Kong stock exchange coincided with a regulatory decision to allow naked short selling in 1995. I expect that the level of efficiency in the stock market will rise in the periods following 1995 due to these additional investment options and changes in regulation. China’s announcement in 2007 gave investors a place to invest their money outside of the Shanghai stock exchange and the Shenzhen stock exchange, both of which have inefficient prices due to constraints on short-sales. A study found that short-sales constraints in stock markets tend to cause stock price overvaluation (Chang, 2004). Because of the high premium on shares traded in Shanghai compared to Hong Kong and the US, I surmise that the opening of the Hong Kong market to Chinese investors created inefficiencies and possibly arbitrage opportunities for global investors. An estimated $100 billion USD of capital inflow within the first year alone would account for 3-4% of expected growth to the market value of the Hong Kong Stock Exchange.
Although mainland Chinese investors did not have direct access to the Hong Kong market until late 2007, anticipation of the entry of optimistic investors would have had an effect on the stock prices at announcement. Given a relatively efficient pricing structure in the free-market Hong Kong stock exchange and an overvalued prices in the restricted Shanghai stock exchange, it is not entirely obvious what would happen to prices when investors are allowed to move from inefficient markets to efficient ones.
In the second half of the paper, I discuss my testing for the following hypotheses: 1) there are long-term cointegrations between the prices of Hong Kong-traded shares and US-traded shares of the same company and 2) the opening of the market to Chinese investors in 2007 caused a period of high price volatility. As a result, the market faced temporary inefficiencies and possible arbitrage opportunities that disappeared once the market caught on. In order to test for cointegration, the Granger causality test requires that the set of underlying time series be stationary. The Dickey-Fuller test, the standard test for autocorrelation, was used to detect whether or not the time series dataset had unit root (Dickey and Fuller, 1979). I then ran the Granger causality test on the first difference series or return time series which was found to be stationary. Finally, I simulated an arbitrage trading rule in an effort to detect if profitable opportunities materialized immediately after the announcement.
Section 2 discusses the theoretical foundations underlying the application and evaluation of the tests for price relationship. The section begins with a discussion of the efficient markets hypothesis and adaptive markets hypothesis followed by a summary of the characteristics of the daily price data collected from the Hong Kong and New York stock markets. Sections 3, 4 and 5 discuss the data set, methodology, and empirical results respectively. Section 6 concludes the paper with a summary of my results from testing the dual market and its importance in understanding price discovery in the Hong Kong stock exchange.
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