Abstract
The purpose of this study is to investigate the relation between investor protection, adverse selection, and the probability of informed trading. Previous research has established a direct relation between investor protection and firm liquidity, measured by bid-ask spreads and depths. In this study, we test the hypothesis that adverse selection is the mechanism through which poor investor protection leads to higher costs of liquidity. The Hong Kong equity market provides a unique opportunity to compare adverse selection differences across distinct investor protection environments, holding constant the trading platform and currency. Using various bid-ask spread decomposition models and probability of informed trading estimates, we confirm the hypothesized relation between investor protection quality and adverse selection costs. These findings contribute to the literature by establishing one of the links in the chain connecting investor protection to firm valuation.
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Notes
Lombardo and Pagano (2001) also examine the role of investor protection in capital markets and find a negative relation between shareholder rights and required rates of return. Recent studies also investigate other aspects of investor protection and provide evidence that stronger shareholder rights and higher disclosure levels are associated with lower cost of capital (Cheng et al. 2006; Zhang and Ding 2006; Eaton et al. 2007).
One disadvantage of using ADRs and cross-listed firms to test the adverse selection hypothesis is that much of their global trading takes place in the home market. Eleswarapu and Venkataraman (2006) show, for example, that the home market share typically represents well over 50% of their ADR’s total trading volume, with percentages of 90% and higher not being uncommon. In contrast, our Hong Kong-based sample is less likely to suffer from a home-bias since the relation between China and Hong Kong is defined as “one country, two systems.” Given the shared history, ethnicity, language, trade, and geographic proximity between China and Hong Kong, a “home-bias” loses much of its meaning in this unique setting.
More specifically, H-shares, red chips, and blue chips are officially categorized by the HSI Services Limited as the Hang Seng China-Enterprises Index, the Hang Seng China-Affiliated Corporations Index, and the Hang Seng Index, respectively.
The probability of trading with an informed trader has also been used as a direct estimate of adverse selection risk (e.g., Chung et al. 2006).
Minor adjustments are made to the time-of-day for the first eight months of the sample period due to an internal clock misalignment in the original data capturing process. These adjustments are made based on information provided by SEHK's Research and Planning officials and verified by our program filters.
The data are compiled on 30 s intervals for the section on bid-ask spread decompositions.
In addition to defining small, medium, and large trades based on firm-specific cutoff points, we also implement a standard cutoff point across all firms. We classify a trade as small if it is less than or equal to 10,000 shares, and large if it is greater than 50,000 share. Medium trade size lies in between. We then re-run the Table 5 estimates with these standard cutoff points. The empirical results (available upon request) are equally supportive of our maintained hypothesis as those reported in Table 5.
Although all versions of the EKOP model are based on the same underlying trade process, this section specifically describes the recent Easley et al. (1998a) version.
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