| Summary: | The study examines the effects of price limits on return, volatility and liquidity by testing three hypotheses: delayed price discovery hypothesis, volatility spillover hypothesis and trading interference hypothesis (Kim and Rhee, 1997, JF). The delayed price discovery hypothesis states that if the price continues to move in the same direction in the subsequent period after a price-limit-hit, the existence of limits delays price discovery. The volatility spillover hypothesis argues that the stock will have a higher volatility after a price-limit-hit. The trading interference hypothesis asserts that a share that hits the price limits on day t will experience more trading on day t+1. The rationale behind price limits is to provide investors with a cooling-off period to counter noise trading and alleviate market panic. If price limits work, all three hypotheses should be rejected. Firms on the Shanghai and Shenzhen Stock Exchanges can simultaneously issue two types of shares: A and B-shares. A-shares were initially traded only by domestic Chinese citizens, but opened to Qualified Foreign Institutional Investors (QFIIs) from July 2003 onwards. B shares were initially traded only by foreign investors but then by local Chinese citizens from June 2001. A and B-shares are subject to the same price limits but exhibit different risk and return characteristics. This study explores the effects of price limits on AB-shares using daily data (intraday data) over the period 2004-2012 (2010-2012). For the first time, this study estimates a GARCH model that explicitly incorporates truncation in the distribution of returns that is induced by price limits. The truncated-GARCH model provides a better fit than a conventional model. Based on the study of daily data, the delayed price discovery and volatility spillover hypotheses are not rejected on either exchange. Similar results have been found in the study of intraday data that price limits are not effective in controlling volatility and counter noise trading. Regarding the trading interference hypothesis, price limits interfere with market liquidity but the level of interference depends on the choice liquidity measures.
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