Three essays on the effect of price limits on the Chinese equity market

Abstract

Price limits, by definition, are artificial boundaries set by regulators to inhibit extremely stock price movements, in an effort to cool off the market from investors’ irrational mania and possible speculative behavior. Although the price limits mechanism has been widely adopted by various markets worldwide, its effectiveness in stabilizing the market is still unverified. In this thesis, I investigate this issue in the Chinese equity market. In chapter 1, by using transaction data and limit order book, I attempt to test whether there exists the magnet effect that attracts the stock prices to move toward their limits with acceleration as stock prices approaching their limits, and if it does, what drives the magnet effect. The logit model suggests that the magnet effect is supported in the Chinese stock market. Moreover, I show evidence that the magnet effect starts to emerge when stock prices move close to their limit within 1% from the upper limits and 0.85% from the lower limits. I find that sub-optimal orders placed by retail investors and actively traded growth firms with higher beta, smaller capitalization, lower BTM value contribute to a higher degree of magnet effect. Investigations into other microstructure variables, in terms of trading volume, volatility and order flow also support the magnet effect. I show that the magnet effect is not symmetric between the upper and lower limit hits. In chapter 2, I focus my research to a daily basis to capture more features of price limits mechanism. I conduct further analysis of what happens in the pre-hit and post-hit periods around a limit hit events. By investigating the three pronounced hypothesis regarding price limit effectiveness, I provides evidence that price limits do impede market efficiency by spreading out volatility, delaying price discovery process and interfering with trading. Moreover, I confirm the asymmetric effect of price limits by presenting evidence that a higher degree of volatility spillover is obtained in upper limit hits. In chapter 3, I take an in-depth sight on the effect of price limits on the Chinese IPO market. The unique arena of changes in trading rules provides an opportunity to examine whether the imposition of first-day price limits changes the IPOs’ short-term performance and affects the IPO underpricing rate. The results suggest that imposing first day price limits induces unfavorable conditions for market effectiveness, in terms of exacerbating abnormal return, interfering trading activity and delaying price discovery process, and changes the way of information asymmetry by providing investors with a certain perception of a continuous limit hitting IPO aftermarket phenomenon, which stimulates investor sentiment, increases their demand for new shares and eventually leads to a higher underpricing rate.