This study examines relation between financial development and the cost of equity capital and finds the following main results: (1) stock market development in general reduces cost of equity, consistent with its role in liquidity provision, information asymmetry reduction, and risk diversification helping to reduce systemic risk; (2) banking development only weakly decreases the cost of equity, consistent with the pervasive state-ownership in large banks constraining their efficiency. Further analysis reveals that the relation between stock market development and cost of equity is more pronounced in large firms and in firms with lower growth potentials, suggesting that stock market development fails to support small and/or growth firms. Moreover, the relation is more pronounced in region with low accounting quality, weak law enforcement, or lower market integration, and in period prior to split share structure reform. The evidence suggests that stock market developments and other institutional arrangements substitute each other in reducing cost of equity. This study contributes to literatures on financial development and cost of equity, and also holds immediate policy implications.

This study examines how corporate governance influences short-term and long-term bidder returns from China’s domestic mergers and acquisitions during 2001-2010. We examine a range of corporate governance measures covering ownership structure, board structure, insider ownership and managerial incentives while controlling for bidder and deal characteristics. Our initial results from events analyses show that market responses differ in ways which suggest a difference in how the market’s assessment of share price from the perspectives of short run and long run. Bidders obtain significant positive abnormal returns over the five-day event period but suffer significant wealth losses for two years following the deal completion. Our further analyses on factors driving the price difference show that executive ownership (positive) and state ownership (negative) exert opposite effects on the announcement period returns. The returns further differ by way of payments with positive (negative) effects from stock (cash) financing. Our long-term regression analyses show that the positive impact of executive ownership remains. Independent directors record a negative effect on abnormal returns. Nevertheless, board independence measured by the composite corporate governance index exerts a significant, positive effect on shareholder wealth. Our study highlights the need for the state to accelerate the share structure reform and formulate policies that encourage executive ownership and sound corporate governance.

Using a sample of China’s listed private firms we investigate the relationship between control-ownership wedge, bank connections and collateral requirement. We find that while control-ownership wedge relates to more pledged collateral, it is mainly the firm’s bank connections rather than its political connections that reduce the collateral requirement and weakens the positive relationship between the control-ownership wedge and collateral. We furhter find that the split-share structure reform and regions with high lender competition also require less collateral and weaken the positive relationship between the control-ownership wedge and collateral. We argue that in an emerging market where legal protection for creditors and investors are weak and relationship is prevalent, bank connections is a substitute for collateral through mitigating the information asymmetry and agency concerns by creditors, which has been further exacerbated due to the tunnelling risk by the controlling shareholders.

Until recently, Chinese companies publicly listed in domestic stock exchanges had two classes of stock: tradable and non-tradable shares. These two classes of stock had the same voting, cash flow, and all other legal rights except that non-tradable shares cannot be transferred at the open markets. From 2005 to mid-2007, Chinese government completed the ownership reform, so-called the Split Share Structure Reform (SSSR), to convert all non-tradable shares into tradable shares. Under this reform process, the holders of non-tradable shares had to negotiate with those of tradable shares to determine how much liquidity premium, or the compensation ratio, non-tradable shareholders have to pay to tradable shareholders in order to obtain the liquidity right. This paper starts with a theoretical model to identify the fundamental factors, including price discount before and after the SSSR reform, the percentage of non-tradable shares in total shares, the volatility of tradable share price, and the lockup period, that should determine the compensation ratio. We show that those factors except price discount before the reform are statistically significant in determining the compensation ratio proposed by non-tradable shareholders. We further show that the agency problems also reveal themselves in the compensation ratios. Specifically, when a firm is controlled by a governmental agency, the compensation is higher. However, the compensation is lower when more concentrated in the top ten holders, especially when shares are held by mutual funds. Thus, the evidence is consistent with the notion that the agency problem exists in China’s fund managers. Finally, we show that the existence of agency problems also reduce the importance of fundamental factors in determining the compensation ratios.

A fundamental question in finance is whether and how removing market frictions is associated with efficiency gains. We study this question using share issue privatization in China that took place through the split share structure reform. Prior to the reform, domestic A-shares were divided into tradable and non-tradable shares with identical cash flow and voting rights. Under the reform, holders of the non-tradable shares negotiated a compensation plan with holders of the tradable shares in order to make their shares tradable. We hypothesize that efficiency gains in terms of better risk sharing play an important role in the determination of compensation. We show that the size of compensation is positively associated with both the gain in risk sharing and the price impact of more shares coming to the market after the reform, and is negatively associated with the bargaining power of holders of non-tradable shares and firm performance. Our study highlights the role of risk sharing in China’s share issue privatization.

China launched her warrant market in August 2005 in the split share structure reform of listed companies. As up to now, equity trading on margin and short-sale of any form are still prohibited in China. This warrant market enables investors to trade on information that otherwise might be prohibitively expensive to trade on. The Chinese warrant market created top trading volume and turnover with only a handful of different warrants traded. This paper first studies the Chinese warrant market. Empirical evidence shows that the market prices of warrants are much higher systematically than the Black-Scholes prices with historical volatility. Moreover, the paper documents ample evidence that the one-dimensional diffusion model does not apply well in the Chinese warrant market. The prices of a warrant and its underlying asset do not support the monotonicity, perfect correlation and option redundancy properties. The paper also studies the cumulated gains of a delta-hedged warrant portfolio. In the Chinese warrant market, the cumulated delta-hedged gains for almost all expired warrants are negative. The negative gains are mainly driven by the volatility risk, and the trading values of the warrants for puts and the market risk for calls. The investors are trading some other risks in addition to the underlying risk.

Trading constraints with unspecified constraint horizon are imposed on the shares held by the state in the IPO of each listed firm in China Stock Market. In 2005, a so-called Split Share Structure Reform (also known as Division Reform) was launched in which the holders of restricted shares give up a proportion of their shares to purchase the right to terminate the trading constraint. From the size of the compensation, we infer the value of restricted shares and find that their price discounts are negatively affected by the restriction looseness captured by our proposed new multi-dimensional measure and positively affected by the bargaining power of the holders of freely-traded shares.

We study the relationship between firm value and related party transactions (RPTs) in China. We find that firm value (as measured by Tobin’s Q) is negatively related to RPTs but the relation becomes insignificant after controlling for corporate governance characteristics. Following Cheung, Rau and Stouraitis (2006), we use abnormal returns in response to announcements of RPTs as a direct measure of the impact of RPTs on firm value. We observe significantly negative abnormal returns before the Share Structure Reform. After the reform, the abnormal returns become insignificant. The evidence suggests that RPTs are not as detrimental to firm value after the reform as they were before the reform. This is consistent with our hypothesis that the reform increases the takeover pressure from external market and thus moderates controlling shareholders’ propensity to tunnel wealth via RPTs.

Prior to April 2005, only one third of the shares issued by exchange-listed companies in China are publicly tradable. The other two thirds, mainly owned by Chinese government agencies or government-linked enterprises, are prohibited from public trading. On April 29, 2005, the Chinese Securities Regulatory Committee announced a reform plan that aims to abolish the split-share structure by converting all non-tradable shares to be publicly tradable. We investigate the consequences of this unique event and shed light on how increase in share float affects liquidity, speculation and stock prices. Firstly, we find that tradable A-shares command a 60% price premium on average over non-tradable A-shares and this price premium contains both liquidity and speculation components. Secondly, the share structure reform increases share turnover and dampens speculative trading. Relative to control firms, share turnover of restructured firms increases substantially after the reform, with the largest increase (107 %) in firms that had low liquidity and low speculative trading before the reform. In contrast. there is no increase in share turnover of firms that had high liquidity and high speculative trading. Thirdly. stock prices drop substantially on the day when the supply of tradable shares increases due to the reform. Moreover. the higher increase in the supply of tradable A-shares. the larger drop in the stock price. This indicates that the short-term demand curve is downward-sloping. Fourthly. despite the fall in stock prices. shareholder wealth increases by 15% on average. We find that the largest price drop and the smallest wealth gain occurs in firms with the highest speculative trading before the reform. which suggests that share structure reform dampens speculative trading in Chinese market. Lastly, split share reform also benefits the B-share market despite that the reform involves only A shares: B-share turnover increases after the reform and the well-known B share price discount narrows substantially .

In 2005 and 2006, the split-share structure reform converted the nontradable shares of most domestic public firms in China to tradable shares. This conversion imparted a drastic supply shock to the public market. Studying this unique event, we provide direct evidence to support an inelastic demand curve for stocks. Abnormal returns of the sample firms resulting from the reform are found to be negatively associated with the size of the supply shock. This finding is free from the confounding information effects present in many prior studies of stock price elasticity. It is also robust after controlling for opposite price impacts of ROA, firm size, and ownership concentration.