The Relationship between Chinese KDR Price and Its Underlying Share Price

This paper investigates the relationship between Chinese KDR and its underlying share issued by Huafeng Group. The underlying share is traded on HKEx(Hong Kong Exchanges and Clearing Limited) and the KDR of Huafeng is traded on KRX(Korea Exchange). Due to globalization in capital markets, cross-border capital flow is stimulated and international cross listing of securities is increased. International investors interested in foreign securities use DR widely. Because DR is based on the underlying share, the underlying share and DR may be priced in the same way. Prior studies found that the price of shares listed in foreign markets is affected by the price of their underlying shares in their home country. This study is distinguished from prior studies in that observed stock price is decomposed into fundamental value and transitory price. Some portion of stock prices is caused by noise trading of irrational traders. Therefore, observed stock price may be defined as the sum of fundamental value and transitory price. Because fundamental value is trend component, it is modelled as a random walk process. And transitory price is assumed as AR(1) process because it passes away with time. The methodological procedures used in this paper are the following steps. As a first step, to decompose observed price, state space model and Kalman filtering method are used. State space model is useful in analyzing a time series model that involves unobservable variables. And Kalman filter is the basic tool to deal with state space model. In this paper, fundamental value and transitory price are unobservable variables. Second, to check for stationarity characteristics of the series, ADF test is used. The appropriate lag order is selected with the use of the SIC. ADF test results suggest that the null hypothesis of a unit root is accepted when observed price and fundamental value are in level, and the null hypothesis of a unit root is rejected at 1% significance level when they are in first differences. If the process of series is found to be a unit root process, the next step is to check the cointegration between KDR and underlying share. If the series are found to be cointegrated, Granger causality in a VECM should be applied. If a time-series of system includes integrated variables of order one and cointegrating relations, then this system can be more appropriately specified as a VECM rather than a VAR. If there is no cointegrating relation between variables, they are to be transformed to stationary processes by differencing the series. Third, to analyze the relationship between KDR price and the underlying share price, this study employs Granger causality test. It is a useful tool to help uncover the direction of causality. Each pair of time series data has different characteristics. In the case of observed price data, two series are nonstationary and they are cointegrated, Granger causality test based on a VECM is applied. Also, in the case of fundamental value data, two series are nonstationary and they are cointegrated, Granger causality test in a VECM is applied. However, in the case of transitory prices, they do not contain trends. Because each transitory price series is stationary, Granger causality test based on a VAR is applied. This paper uses daily data running from 26 November 2007 to 27 February 2009. Because Korean stock market holidays differ from Hong Kong stock market holidays, the corresponding date which is a holiday in another country is deleted in the data set. The main empirical results of this paper are as follows. First, there exists bidirectional causalities between the observed price of the underlying share and the observed price of KDR at 1% level of significance. This means that there exists the significant linkage between two securities. This finding is similar to the results from Park and Kim(2001), Yae and Chung's(2007) empirical findings.