The Price Discovery and Price Leadership of Foreign Investors: Evidence from Taiwan Futures Markets

The price discovery and price leadership of foreign investors: Evidence from Taiwan futures markets Wei-Kuang Chen Professor, Department of Money and Banking, National Chengchi University Ching-Ting Lin* Assistant professor, Department of Money and Banking, National Chengchi University Cheng-Yi Shiu Professor, Department of Finance, National Central University Abstract Using a unique dataset composed of comprehensive transaction data from Taiwan futures markets, we classify all investors into individuals, domestic institutions, and foreigners, and examine the price discovery and price leadership for these three groups. We find that, despite the relatively low trading volume of futures contracts by foreigners, such trades make a significant contribution to price discovery. Moreover, intraday analysis shows that foreigners’ correlated trades can positively predict concurrent and future price movements of futures contracts. The empirical result indicates that foreigners have an information advantage in Taiwan futures markets. In contrast to foreigners, individuals make the least contribution to price discovery and their correlated trades negatively predict the following price movements, suggesting that individuals have an information disadvantage. Keywords: Price discovery; Price leadership; Herding; Foreigners; Information role *Corresponding author. Department of Money and Banking, College of Commerce, National Chengchi University, Taipei, Taiwan, R.O.C., Tel: +886-2-29393091 ext. 81248, Email: [email protected]. 1 1. Introduction Literature on the informational role of foreign investors expresses diverse views. One tranche of literature asserts that domestic investors are more knowledgeable than foreign investors about the local environment or domestic firms. For example, Choe, Kho, and Stulz (2005) analyze all trades in the Korean stock market and find that domestic investors are better able to select winners than foreigners. Dvorak (2005) uses transactions data from Indonesian stocks and shows that domestic investors have better trading performance than foreigners. In contrast, another tranche of literature argues that foreigners may have better technological, financial, or human expertise, experience, or resources than domestic investors. For example, Grinblatt and Keloharju (2000) use daily data and find that foreigners are better able to select winners in Finnish stocks than domestic individuals. Ferreira and Matos (2008) demonstrate that non-U.S. firms with higher foreign ownership have higher firm valuation and better operating performance. Huang and Shiu (2009) investigate firm-level data and show that stocks with high foreign ownership outperform those with low foreign ownership in Taiwan stock markets. In addition to stock markets, the superior performance of foreigners has also been revealed in options markets (Chang, Hsieh, and Wang, 2010) and futures markets (Kuo, Chung, and Chang, 2015). Although the existing literature remains divided on whether domestic or foreign investors have an information advantage, the measure of information advantage or disadvantage for a group of investors remains an interesting issue for academic research. According to the efficient market hypothesis, when new information about the value of a security arrives in the market, it should be incorporated into the stock price quickly and correctly. However, market friction and imperfections, such as transaction costs, taxes, 2 regulations, or asymmetric information, can injure market efficiency by preventing new information from being impounded into stock prices quickly and correctly. In such an environment, it could happen that a specific group of investors may be better equipped to select winners while another specific group of investors may be better equipped to discover equilibrium prices. This brings one to the question of whether better trading performance equals a better contribution to information processing. It is necessary to examine the contribution to price discovery and trading performance simultaneously before one can make conclusions regarding the information advantage of a specific group of investors. In this paper, we explore the issue of whether domestic or foreign investors have an information advantage by analyzing the transactions of all investors in the futures markets in an emerging country. Our unique dataset consists of the complete historical orders, investor records, and identities of all investors in the Taiwan Futures Exchange from January 2003 to December 2008, allowing us to perform a detailed analysis of transactions and prices of the futures contracts. According to investors’ identities, we categorize investors as individuals, domestic institutions, or foreigners. We then examine the contribution to price discovery and trading performance, respectively, of these three groups. We are particularly interested in understanding whether there are differences in the contribution to price discovery and trading performance among these three groups. More specifically, to address the issue of whether domestic or foreign investors have an information advantage, we examine two measures for the three different investor groups: contribution to price discovery and trading performance. For the measure of the contribution to price discovery, we follow Hasbrouck (1995) and Lien and Shrestha (2014) to calculate the information share (IS). Hasbrouck (1995) 3 assumes that shares of one security are traded in multiple markets. The transaction prices in each market are decomposed into unobservable permanent prices, which reflect the fundamental value of the security, and transitory errors. The IS of a market is the contribution of the permanent price changes in this market to the revelation of the common efficient prices. The framework of IS provides us with a method to measure the contribution to price discovery for different types of investors. In this paper, we assign transaction prices to three different investor groups based on the identity of the investor who initiates the trade. We then calculate IS for the three investor groups. Although many studies have used IS to measure the information content of equity prices, this method suffers from two limitations: it can only be used in situations where each pair of prices is cointegrated with a one‐to‐one relationship, and it involves upper and lower bounds. Lien and Shrestha (2009) modify the IS method so that a unique measure of IS can be achieved. Lien and Shrestha (2014) further propose the generalized information share (GIS) method, which could be applied to cases where the prices are cointegrated but the cointegrating vector does not have to be a one‐to‐one relationship. As an application of the GIS proposed by Lien and Shrestha (2014), we analyze the price discovery process of the futures contracts traded by the three investor groups. For the measure of trading performance, we examine the association of investors’ correlated trades and concurrent and future returns of the futures contracts. The relationship of a concurrent return with the correlated trades in a group of investors is related to whether the investors’ trades can move concurrent prices, while the future return predictability is the measure that is most likely to reflect differential information among investors. To investigate the investors’ correlated trades, we use the herding measure proposed by Lakonishok, Shleifer and Vishny (1992) (hereafter LSV) and buy- 4 sell imbalance. The results are as follows. First, despite being the smallest group of investors in terms of trading volume, foreigners play the dominant role in the price discovery process in Taiwan futures markets. For example, in 2008, foreigners account for only 10.5 percent of trading volume for TXF, which is the most liquid market index futures contract, but contributes 69.5 percent of price discovery as measured by the GIS method. For comparison, individual and domestic institutions account for 66.7 percent and 22.8 percent of trading volume but only contribute 6.3 percent and 24.3 percent of price discovery, respectively. Second, foreigners’ correlated trades have a clear, positive association with concurrent and future returns of futures contracts. The positive relationship is revealed in both LSV measures and buy-sell imbalances. In contrast, individuals’ correlated trades have a significant negative relationship with concurrent and future returns. The result indicates that foreign investors as a group have the best trading performance while individuals have the worst performance in the Taiwan Futures Exchange. Domestic institutions lie between foreigners and individuals. This study contributes to the existing literature regarding the debate on whether domestic or foreign investors have an information advantage. Overall, our empirical results show that foreigners not only make the greatest contribution to price discovery but also have the best trading performance, suggesting that foreigners have an information advantage over domestic institutions and individuals in the Taiwan Futures Exchange. Our result showing that foreigners have an information advantage is consistent with the findings in Grinblatt and Keloharju (2000), Ferreira and Matos (2008), and Huang and Shiu (2009). Our finding showing that individuals are naïve, uninformed investors which 5 is also consistent with the empirical results from the Taiwan stock market documented in Barber, Lee, Liu, and Odean (2009), Chiang, Hirshleifer, Qian, and Sherman (2011), Chen, Chow, and

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