Trading restrictions and stock prices:

(1)

Trading restrictions and stock prices:

Robin Greenwood

Harvard Business School

QWAFAFEW Boston

October 17, 2006

(2)

Greenwood Trading Restrictions and Stock Prices

Trading Restrictions

• Trading restrictions reduce ability of liquidity

providers to dampen uninformed security demand. • Trading restrictions vary significantly across

countries and firms.

• This paper: Some firms may take active measures to make prices further deviate from fundamentals by imposing trading restrictions on their investors.

• Presents a theory of trading restrictions (“float

manipulation”), tests theory using data from period of heavy trading restrictions in Japan.

(3)

Trading restrictions and float

• Float refers to the number of shares available to trade by ordinary investors

• When trading restrictions are in place, the number of shares available to trade is low.

• When the number of shares available to trade is low, small shocks to demand can have large effects on prices:

(4)

Float Manipulation via Stock Splits: Japan

• Following the ex-date of a stock split, the new shares are not distributed to shareholders for several weeks.

• Nikkyu stock split:

June 5, 2004 Announcement date Announces 21-for-1 stock split July 28, 2004 Ex-date Owners of 1 old share at the

close of this day are entitled to 20 more new shares

September 19, 2004

Pay-date

20 new shares are delivered. Old shares convert automatically into new shares

(5)

Float Manipulation via Stock Splits

• Hypothetical Owner of 1% of firm

• Forward Position does not trade for 3-9 weeks. Effective supply of shares drops by 20/21 (95%)!

June 5, 2004 Announcement date Spot Position: 1% Forward Position: 0 July 28, 2004 Ex-date Spot Position: 1/21 % Forward Position: 20/21 % September 19, 2004 Pay-date Spot Position: 1%

(6)

Greenwood Trading Restrictions and Stock Prices Trading Restrictions (Float Reduction)

10-for-1 5-for-1 4-for-1 3-for-1 2-for-1 1.5-for-1 1-for-1 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 0 10 20 30 40 50 Split Ratio

(7)

What happens when restrictions are imposed?

• Prices rise rapidly (sometimes over 100%) • Firms engage in several activities

– More likely to sell shares

– Issue convertible debt in advance to allow issuance of equity – More likely to announce acquisitions

(8)

Ability of investors to trade…

0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09

0.10 [Announcement] [Ex-date] [Pay-date]

4 ≤ Ratio < 5 Ratio≥100 2 ≤ Ratio < 3 1.5 ≤ Ratio < 2 3 ≤ Ratio < 4 1 ≤ Ratio < 1.5 5 ≤ Ratio < 1010 ≤ Ratio < 100

(9)

Event Returns and Trading Constraints

-50% 0% 50% 100% 150% 200% 250%

Ann-4 Ann+2 Split Split+6 Split+12 Split+18 Split+24 Split+30

100 ≤ Ratio 10 ≤ Ratio < 100 5 ≤ Ratio < 10 4 ≤ Ratio< 5 3 ≤ Ratio < 4 2 ≤ Ratio < 3 1.5 ≤ Ratio < 2 1 ≤ Ratio < 1.5

(10)

Pay-date returns and trading restrictions

-60% -50% -40% -30% -20% -10% 0% 10% 20%

Pay-15 Pay-9 Pay-3 Pay+3 Pay+9 Pay+15

100 ≤ Ratio 10 ≤ Ratio < 100 5 ≤ Ratio < 10 4 ≤ Ratio < 5 3 ≤ Ratio < 4 2 ≤ Ratio < 3 1.5 ≤ Ratio < 2 1 ≤ Ratio < 1.5

(11)

Plan

• Introduction

• Theory of trading restrictions and stock prices • Trading restrictions via stock splits

• Empirical Tests

• Evidence for Manipulation • Conclusion

(12)

A Theory of Trading Restrictions

• Four periods: 0, 1, 2, 3

• Single risky asset in fixed positive supply of 1 share, pays liquidating dividend D=F+ε

• Four important assumptions:

– Investors trade

– Investors cannot go short

– The stock split constrains investors from trading. Specifically, investors with a long position of x must hold a long position of kx during stock split, where k=1-1/S.

(13)

Predictions

• Period of float reduction limits ability of investors to trade.

• Reduction of float = Severity of Constraints

– Cross-sectionally related to increase in prices (Proposition 1)

• Trading volume = Likelihood that constraints bind

– Trading volume cross-sectionally related to increases in prices (Proposition 2)

• Interaction of trading volume and severity of constraints related to increases in prices.

(14)

Comparative Statics

• Proposition 1. The event return is positive and increasing in trading restrictions k, trading intensity

H, and the interaction.

2 1 0 1 0 1 0 ( ) ( ) ( ) 0 ; 0; 0. d P P d P P d P P dk dH dHdk − − − > > >

(15)

P

Q

kQ₀

(16)

Japan’s Stock Split Bubble

• Before 1999, over 95 percent of stock splits were in ratios of 1.3-for-1 or less.

• Press accounts indicate that stock splits were used as attempt to maintain constant dividend-per-share. • During 1990s

– Rules changing brokerage commissions were changed.

– Rules on NA/Share were repealed, allowing low priced shares

• Consequences

– Firms started to split in larger ratios – Number of splitters went up

(17)

Split ratios: 1995-2004

127 29 218 86 26 43 29 132 28 98 ₃₀ 10 12 10 215 43 57 15 1 ₂ ₁ 277 13 ₂ ₀ ₀ ₀ ₀ 565 12 2 0 0 0 ₀ 0 100 200 300 400 500 600 Number of Firms <1.5 <2 <3 <4 <5 <10 >=10 1995-1996 1997-1998 1999-2000 2001-2002 2003-2004 Split Ratio

(18)

Returns on stock splits

-0.05 0.00 0.05 0.10 0.15 0.20 0.25 0.30 0.35

2003-2004

2001-2002

1999-2000

1995-1996 1997-1998

(19)

Event Returns and Trading Constraints

-50% 0% 50% 100% 150% 200% 250%

100 ≤ Ratio 10 ≤ Ratio < 100 5 ≤ Ratio < 10 4 ≤ Ratio< 5 3 ≤ Ratio < 4 2 ≤ Ratio < 3 1.5 ≤ Ratio < 2 1 ≤ Ratio < 1.5

(20)

Event Returns and Trading Restrictions

[Table 5]

R = Event return [Announcement day – 1, Ex-date + 10]

Full Sample Split Ratio ≥ 2 (k≥0.5)

(1) (2) (3) (4) (5) (6) Constant _{-0.05 0.10 -0.03 -0.73 0.26 -0.57} [-4.44] [11.10] [-2.24] [-7.18] [9.41] [-5.34] k = 1 – 1/Split Ratio _0.64 _{0.45 1.69} _1.35 [19.53] [11.75] [10.35] [7.29] Turnover _{4.58 9.51} _{2.50 7.67} [7.52] [11.37] [2.25] [5.02] k x Turnover _10.28_6.89 [8.68] [3.26] R2 _{0.15 0.03 0.20 0.14 0.01 0.17}

(21)

Pay-date returns and trading restrictions

-60% -50% -40% -30% -20% -10% 0% 10% 20%

Pay-15 Pay-9 Pay-3 Pay+3 Pay+9 Pay+15

100 ≤ Ratio 10 ≤ Ratio < 100 5 ≤ Ratio < 10 4 ≤ Ratio < 5 3 ≤ Ratio < 4 2 ≤ Ratio < 3 1.5 ≤ Ratio < 2 1 ≤ Ratio < 1.5

(22)

Pay-date returns and trading restrictions

Full Sample Split Ratio ≥ 2 (k≥0.5)

Constant _{0.02 -0.02 0.01 0.16 -0.07 0.11} [4.56] [-6.18] [2.99] [4.78] [-8.38] [3.09] k = 1 – 1/Split Ratio _-0.19_-0.14_-0.41_-0.29 [-14.84] [-8.99] [-7.60] [-4.79] Turnover _-1.92_-1.85_-1.03_-1.86 [-8.17] [-5.41] [-2.92] [-3.67] k x Turnover _-2.86 _-2.47 [-5.93] [-3.52] R2 _{0.10 0.03 0.20} _{0.08 0.01 0.10}

(23)

Alternative Explanations

• Information/liquidity/signalling theories of stock splits

– Fischer, Jensen and Roll (1969) – Lakonishok and Lev (1987)

– McNichols and Dravid (1987)

– Asquith, Healy and Palepu (1989)

• These theories explain the returns on announcement of the split only– they cannot explain the predictable returns around the ex-date and around the pay-date.

(24)

Evidence for Manipulation

• Must be some benefit to higher stock price

– Longer-term visibility of stock?

– Ability of management to sell overpriced stock

– Ability to acquire other firms in stock financed mergers

• If manipulation, expect firms to respond to changes in the split premium

(25)

Evidence for Manipulation

• Convertible bond issuance prior to split

(26)

Evidence of Manipulation

• More splitting at higher ratios…

-0.20 0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60 1.80 95Q1 95Q3 96Q1 96Q3 97Q1 97Q3 98Q1 98Q3 99Q1 99Q3 00Q1 00Q3 01Q1 01Q3 02Q1 02Q3 03Q1 03Q3 04Q1 04Q3 Sp lit P re m iu m 0 10 20 30 40 50 60 70 80 90 100 N um be r S plit A nn ou nc em en ts

(27)

Evidence of Manipulation

• Regulatory and market responses

– Tokyo Stock Exchange disallows splits of ratios of 5-for-1 or greater.

(28)

Applications

• IPOs

– Firms may actively manipulate the float during an IPO in an effort to keep the price high

– Effect may be more severe when collusion present among the original owners of the security.

– Possible role of regulator in keeping float high.

• PIPEs

– Issuers offer discounted equity to parties who agree not to trade. When the restrictions are lifted (ie, the equity is registered),

(29)

Float and Stock Prices

• General principle: Reducing Float increases the price impact of trade

-0.02 0.00 0.02 0.04 0.06 0.08 0.10 0.12 0.14 0.16 A nn-2 A nno unc em en t A nn+ 2 A nn+ 4 A nn+ 6 A nn+ 8 An n+ 10 An n+ 12 An n+ 14 An n+ 16 An n+ 18 An n+ 20 An n+ 22 An n+ 24 An n+ 26 An n+ 28 An n+ 30 An n+ 32 An n+ 34 An n+ 36 An n+ 38 An n+ 40 An n+ 42 An n+ 44 An n+ 46 An n+ 48 An n+ 50 CA R ( % )

(30)

Float and mispricing

• Mispricing more likely in low float stocks

– China A/B share arbitrage – ADR mispricing

– Marking the market among focused funds

– Mutual fund flows have significantly larger price impact among low float stocks