Valuing the premium in Chinese stock markets using exchange options

This paper examines the stock prices of Chinese companies dual-listed in the A and H share markets between January 2006 and March 2008. While most previous studies have concluded that the A share market does not have significant exposure to the Hong Kong market, I find that following the introduction of the Qualified Domestic Institutional Investor regime in May 2006 the premium in the A share market corresponds closely with the value of an exchange option calculated using a modified version of Margrabe's formula. The explanation for this result is simply that the current prices of dual-listed securities in Shanghai are reflecting both a fundamental value for the security and the expected value of arbitrage profits available by trading in Hong Kong. I consider the theoretical basis for this result by reference to recent work in behavioral finance by DeMarzo, Kaniel and Kremer (2004) and (2007), and discuss the implications for both policymakers and traders.