Information use and transference among legally separated share markets--an experimental approach.

AuthorQi, Li
  1. Introduction

    Foreign share ownership restrictions have been a common practice at different times in almost all emerging capital markets. (1) They come in various forms to protect domestic industries while serving the purpose of attracting foreign capital. Several countries with emerging capital markets have adopted legally separated share markets (LSSM), in which local firms can market separate claims to the same underlying dividend flow to two distinct sets of investors: domestic shareholders who can buy "A" shares with domestic currency and foreign investors who can only buy "B" shares with foreign currency. For example, in China, local firms issue A shares to Chinese citizens who can only trade A shares with Chinese currency, yuan (2); firms can also issue B shares to foreign investors who can only trade B shares with U.S. currency. (3) A and B shares carry the same economic and voting rights.

    The efficient market hypothesis (EMH) would predict that the prices of both assets, though having segmented trading markets, should reflect the best available information if the markets are efficient. Thus, even if we presume that one market has more information about the asset (for example, local traders may have more information), the price of the asset in the other market should reflect that information as well. There is some indirect empirical evidence of information transference among the segmented markets. Previous studies have documented the covariance in the price movement of Chinese A and B shares (Chakaravarty, Sarkar, and Wu 1998; Chui and Kwok 1998; Kim and Shin 2000), even though the prices of these two shares diverge. (4)

    While there are good theoretical reasons to believe that shares traded in LSSM need not have the same price level in equilibrium, what remains to be understood is whether information from one market can be transferred across to the other segmented market (whether EMH would prevail even in LSSM) and what factors affect this transference process and its underlying impacts on market outcomes.

    Some individuals may have better information about the determinants of dividend flows that can be generated by a given enterprise than others. Initially uninformed traders have an incentive to attempt to glean this information from price movements in asset claims to these dividends. Informed traders, or "insiders," in turn have an incentive to take advantage of their information before uninformed traders are able to infer what the insiders already know. The EMH implies that in equilibrium the market prices for these assets will eventually reflect the best available information, regardless of where that information initially resides or how insiders behave. The hypothesis is silent with regard to how those with inside information fare relative to initially less well-informed traders as the trading process unfolds. Our objectives in the research described are threefold: First, we wish to test whether the inside information possessed by some traders in one LSSM is reflected in the equilibrium prices of both asset markets. This puts the EMH to a more stringent test than previous studies of a single asset market. Second, we wish to observe how insiders behave and what profits they secure from their informational advantage under different market conditions. Third, we wish to see how the presence of insiders affects the behavior of outsiders.

    Foreshadowing our results, we find that inside information, which is available only to some participants in one market, does transfer to the other market and influence prices in both markets. The extent of this transfer depends upon whether the location of insiders is publicly known, how close the market price in the market with informed traders gets to the full information revealing equilibrium, and what the variance in transaction prices is within market A (that is, the quality and clarity of signals sent out by the market with insiders). We also find that insiders' behavior and performance is significantly affected by the public's knowledge of the location of insiders. Efforts by insiders to manipulate the market increase dramatically when the location of insiders is unknown to the public. On average, such efforts pay off to the whole group of insiders but not to the initiator of these manipulative transactions. The behavior of uninformed traders also responds to the knowledge that some traders have inside information.

    We discuss the related literature in section 2 and present the design of the experiment and the hypotheses we wish to test in section 3. We present the the experimental results and analysis in section 4 and summarize our conclusions and future research plans in section 5.

  2. Literature Review and Research Motivation

    Previous experimental studies with regard to information transmission in a single market (that is, a single group of traders) have focused on two types of situations: one where insiders hold perfect knowledge of what the state will be, and one where no individual knows exactly what the true state is, but if private information is aggregated, the true state will be revealed.

    In both of these settings there is a basic setup: There is one asset whose dividend flow is state dependent, and the other is a trading currency that pays a dividend independent of state. The difference in the private value of the state-dependent dividend to different experimental subjects serves as the criterion to separate subjects into different types of investors.

    Previous studies show that, in general, insider information is reflected in market prices; although, this is not always observed. For example, in the case of perfect insider information, information revelation for one-period assets could be observed in the experiment of Plott and Sunder (1982), with dividend payments dependent on three states and three trader types, who differed only with regard to the payoff associated with each of the possible states.

    In the case of partial private insider information, information aggregation is observed, but it does not happen all the time. Plott and Sunder (1988) study markets where traders had different information, and the information structure was collectively complete; that is, traders' collective information completely identified each trader's payoff. They demonstrate that a complete set of Arrow-Debreu securities help to aggregate information. Forsythe and Lundholm (1990) examine the extent to which markets actually aggregate and transmit information. They find that trading experience and common knowledge of dividends are jointly sufficient to achieve rational expectation equilibrium but that neither is a sufficient condition by itself.

    But information aggregation does not work well in complicated environments. Studies extending the possible number of states governing dividend payoffs (for example, O'Brien and Srivastava 1991) and the number of securities simultaneously traded fail to observe information aggregation. Moreover, recent studies also show the possibility of an "information trap"--a sort of equilibrium in which information existing in the market does not become revealed in prices (Noeth et al. 1999). These efforts are designed to test the limits of the market information aggregation. Most of the extensions have been in the direction of reaching more complicated environments, such as the number of possible states and securities.

    However, the process and impact of information revelation (or aggregation) across segmented markets have not been studied. Will the power of simple environments, in which information transmission has been proved to exist, also support information transmission across separated markets that represent the same dividend flow? If so, what does this mean to asset pricing in those markets? The market structure inspired by the LSSM phenomenon provides a good opportunity to study insider behavior and its direct impacts on the market outcomes. Existing literature on market microstructure looks at how different trading rules affect the ability of traders who could act strategically to actually influence market prices. (5) We do not use various trading rules and market structures as treatment variables. Rather, we investigate the information revelation process and insider behavior across segmented markets under a fixed set of trading rules.

    We extend the testing of market efficiency and information revelation to a new dimension by studying the flow of information and its impact across segmented markets. While most of the existing experimental studies on asset markets focus on aggregate market outcomes, our study also probes insiders' pricing strategies and portfolio choices.

  3. Experimental Design

    The Environment

    We recruited subjects from the undergraduate student population at the University of Pittsburgh and Georgia State University for a computerized double auction asset market. (6) No experienced subjects were used, and no subjects participate in more than one session. There are 12 subjects for each session, and they are divided into 2 groups of 6 subjects each: one is the domestic player group and the other is the foreign player group (we avoid using the terms domestic versus foreign in our instructions; subjects know only group 1 versus group 2). Members of each group may trade among themselves but cannot trade with members of the other group. Trading takes place through a computer interface. Subjects can observe trading activity in both markets, but can only trade in the market to which they have been assigned. Figure 1 is a replica of the trading screen seen by a subject.

    In this experiment, each group has two assets: One asset pays a state-dependent dividend, and the other is a trading currency that pays a dividend independent of state. Each subject starts with l0 units of stocks (either A or B, depending on the group to which they belong) and 3500 units of trading currency. Each asset pays its dividend at the end...

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