RDP 2003-06: The Characteristics and Trading Behaviour of Dual-Listed Companies 6. Testing for Changes in Market Exposures Following Unification of DLCs

We next explore another aspect of the excess comovement phenomenon based on a different group of DLCs. In particular, we exploit the fact that six DLC structures have been discontinued within the last decade, and replaced with a more conventional single company structure. These firms are listed in Table 5, and some further details of the unification of their share structures are provided in Section 7.

In cases where two companies become one, the listing arrangements typically change from two primary listings to a single primary listing in one market and a secondary listing in the other. In some cases the company may remain in the national market index of the country that is now the secondary listing, but international index providers such as Morgan Stanley Capital International (MSCI), Dow Jones and Bloomberg typically transfer the entire index weight to the country of the new primary listing. This is likely to have implications for the location of the trading of the company's shares, with a shift towards the market of the new single primary listing. However, if markets are perfectly integrated and the fundamentals, or firm-specific risks, associated with the combined company have not changed then the exposures of the combined firm to various markets should not have changed.

However, studies have shown that location of trade and the way that stocks are traded can influence stock prices. In addition to Froot and Dabora (1999), Chan, Hameed and Lau (2003) investigate the case of the Jardine Group companies that shifted their listings from Hong Kong to Singapore in 1994. They find that the stocks became more correlated with the Singapore market after the change in listing, despite the core business of the group remaining in Hong Kong. Two other related examples are studied by Barberis, Shleifer and Wurgler (2002) and Sosner and Greenwood (2002), who examine changes in correlation following inclusions or exclusions from major stock indices, namely the US S&P 500 index and the Japanese Nikkei 225 index, respectively. Both sets of authors find that when a stock is added to an index it becomes substantially more correlated with the other stocks in that index, and less correlated with stocks that are not in the index, with an equivalent impact for deletions from an index. The unification of a DLC provides another opportunity to examine how stock prices are affected by trading-related factors.

The prediction of a model of trading-induced comovement is that following the unification of a DLC and the shift to a single primary listing on one market, the exposure of the market value of the combined group to the market index of the market of the new single primary listing will rise. Similarly, there should be a fall in the market exposure of the combined group to the market that no longer has a primary listing. That is, just as the existence of a DLC arrangement allows for predictions about comovement, so to does the unification of a DLC arrangement into a conventional merger.

We test the prediction of trading induced comovement by estimating a model similar to that estimated by Chan, Hameed and Lau (2003) and focusing on four unifications where there are clear predictions about market exposures. We regress the return of the combined company, both before and after unification, on the returns of the market indices of the two markets where the DLC traded. The return on the combined company post-unification is directly observed from the trading of the company on the new primary or new secondary market. However, we do not directly observe the return on the combined company in the pre-unification period. Hence, we calculate it as:

where α is the weight of the twin (company α) in the market that becomes the new primary listing, 1-α is the weight of the twin (company b) that becomes the new secondary market listing, and are the returns of the respective companies, and is the change in the exchange rate between the two countries in question.

Although the problem of differences in trading hours is not a significant issue for the DLCs that have unified, we take account of possible non-trading effects or asynchronicity of trading by estimating market exposures using 2-day returns (though the results are not especially sensitive to this).^[23] We test for a change in market exposures by estimating the following equation:

where and are the log returns of the market indices for the new primary and new secondary market indices, respectively, and D_t is a dummy variable taking the value zero in the pre-unification period and unity in the post-unification period.^[24] We estimate this regression using data for 200 days prior to the announcement of unification, and 200 days post-unification beginning 20 days after the first trading day as a unified company.^[25]

The parameter estimate on the dummy interaction terms provides the test for whether there has been a significant shift in market exposures. The null hypothesis that the market exposures of the combined company are not affected by the changed trading arrangements is that these dummy interaction terms are zero. The alternate hypothesis of a change in market exposures due to changed trading arrangements is that will be positive and will be negative.

Although we have data for six unified DLCs, we omit two of these in conducting the tests for changes in betas. In the case of Merita Nordbanken, the Finnish-Swedish financial group (which was renamed Nordea following its unification), the announcement of the unification of the share structure was accompanied by the announcement of a takeover of Norway's Christiania Bank. We omit this case since the takeover could have resulted in a fundamentals-based change in the market exposures of the combined company. We also omit the case of the Belgian-Dutch Fortis financial group because the unification was accompanied by the announcement that the group would retain dual primary listings. Indeed, different providers of regional and global indices have taken different decisions as to which of the two listings is included in their indices.

This leaves four cases where the unification of the share was not accompanied by any changes in the underlying business of the group and where the unification announcement explicitly stated that one particular market would become the new primary market for the group. These include: ABB, the Swiss/Swedish industrial conglomerate; Dexia, the Belgian/French financial firm; SmithKline Beecham, the Anglo-American pharmaceutical company which has subsequently merged with Glaxo Wellcome to form GlaxoSmithKline; and Zurich Allied/Allied Zurich, the Swiss/UK insurer which is now called Zurich Financial Services.^[26] In these cases, although the merged company remained in the market index of each country,^[27] the combined group is treated by all major global index providers (including MSCI, FTSE, Bloomberg, and Dow Jones) as belonging entirely to one market.

The results for the tests for changes in market exposures following DLC unification are shown in Table 6. The results provide very clear evidence that the betas of the combined firm change very markedly following the unification of the share structure. Furthermore, the results are exactly as would be predicted by a model of trading-induced comovement. In particular, the beta for the market that becomes the single primary listing for the merged company rises in all cases by about 0.4 and there is a corresponding fall in the beta for the market that is now the secondary listing. All the estimated changes are significant at the 10 per cent level, except for the estimate for in the SmithKline Beecham regression, where the result appears to reflect an atypical low parameter on the US market in the particular pre-unification sample that was used.

One possible explanation for the change in market exposures might be that the value of the unified firm is measured solely on the market that is now the primary listing, whereas the value of the pre-unification combined firm is measured partly in the market which is now the secondary market listing. Hence, it could potentially be the case that the shift in betas is due to the change in the source of prices for the pre- and post-unification returns. This possibility was examined by estimating Equation (3) with post-unification returns calculated from market prices on the secondary market (and changing the currency of measurement for the pre-unification returns.) The results of this alternate test are almost identical to the results shown in Table 6, which is not surprising since the prices of the unified company are essentially equal on the primary and secondary markets.

Hence, we conclude that even though there is no change in the fundamental exposures of these companies, the conversion of a DLC arrangement into a conventional merger results in substantial changes in exposures to the two markets where the DLC twins previously traded. Since unification results in changes in the twins' weights in global and regional indices, this result corresponds closely to the results of Barberis, Shleifer and Wurgler (2002) and Sosner and Greenwood (2002), who find related results for index inclusions and deletions in the United States and Japan. In addition, the shift from two primary listings to a single primary listing is somewhat analogous to the relisting of the Jardine Group companies studied by Chan, Hameed and Lau (2003), and our results are also very similar. Overall, our results are exactly as would be predicted by a model of trading-based comovement, whereby the pricing of assets is partly determined by the location of trade and the investors who trade them.

Footnotes

All are cases of European firms with no more than one-hour's difference in trading hours, with the exception of SmithKline Beecham which traded in the US and UK and was subject to a five-hour difference in trading hours. [23]

For presentational purposes, the model and results we present exclude the change in the exchange rate as an additional explanatory variable. The results are, however, broadly similar if this is also included. [24]

By combining the pre- and post-unification data into a single regression, we are implicitly making the assumption that the variance of the residual is equal in the two different periods, an assumption which is not rejected by Chow tests. [25]

The post-unification primary market is listed first where applicable. [26]

An exception is Allied Zurich, which was deleted from the FTSE 100. [27]