Capital controls, market segmentation and stock prices: Evidence from the Chinese stock market

This paper provides an asset pricing theory of the segmented Chinese stock markets. In Chinese stock markets, a local firm issues two classes of shares: A shares are available only to Chinese citizens, and B shares are available only to foreign citizens. In a setting where domestic investors can invest only in A shares and foreign investors can invest in both B shares and other foreign shares, the price differences between B shares and B shares depend on investors' attitudes toward risk, the correlations between B shares and foreign shares and investors' expectations about future returns. The empirical implications of this theory are supported by evidence in China's stock market. Cross-sectional differences between prices of A shares and B shares are correlated with investors' attitudes toward risk and correlations between B shares and foreign shares. Time series variability in the discounts of B shares is highly positively correlated. However, the discounts are not correlated with real interest rates. Regulatory changes may explain part of the variability of B shares' discounts over time.