The Chinese discount puzzle

Abstract

When foreigners' equity investment is restricted, shares held by foreign investors tend to trade at a premium relative to those held by local investors in all the countries with such restrictions. The only

exception to this is China, where B-shares held by foreigners trade at substantial discounts relative to A- shares that the Chinese investors hold. In this paper, we offer an explanation for this puzzle based on an

asset pricing model that allows for several key characteristics of the Chinese capital markets, i.e., (i) Chinese and foreign investors face different risk-free interest rates; (ii) Chinese investors are prohibited • from holding B-shares, and foreigners from holding A-shares; (iii) Only a subset of Chinese firms issue B-shares; and (iv) The Chinese have no legal access to foreign capital markets. The pricing model shows that a firm's B-share discount is positively related to the world covariance risk of B-shares, negatively to the Chinese covariance risk of A-shares, and positively to the difference between the world risk-free interest rate and the Chinese rate. In addition, the inaccessibility of foreign securities for Chinese investors is shown to contribute to B-share discounts by inducing foreigners to reduce their demand for B-shares. Our empirical tests generally support the implications of the pricing mode