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Capital Markets

Explaining the Price Anomaly of KRX

Preferred Stocks

Inhyung Lee, Senior Research Fellow*

I. The Present Conditions of Preferred Stocks and Problems

1. Current conditions of preferred stocks

A few of the listed preferred stocks at the Korea Stock Exchange (KRX) exhibit

abnormal prices, irrespective of the economic fundamentals of the issued company. The

main reason behind the discrepancy is illiquidity for the preferred stocks. Disruptive

price movements of these stocks are causing concerns regarding investor protection,

prompting the exchange authorities to review the current rules and standards governing

the listing requirements for preferred stocks. The empirical analysis performed in thisarticle is aimed at revealing the causes of irregular price formation.

As of October 17, 2010, the number of companies that issued preferred stocks was

123, comprising 17.1% of all the listed companies, while the number of listed preferred

stocks totaled 149. The number of newly issued preferred stocks after the revision of the

Commercial Act in October 1996 was 34, which is 22.8% of the total preferred stocks,

while the number of companies that issued the new preferred stocks is 25.

The total market capitalization of the 149 preferred stocks is 22.7 trillion won, which

is 5.06% of the total KOSPI market capitalization. In terms of the outstanding number

of shares, there are 466 million shares, which is just 1.26% of the total. Of these stocks,

12 of them have less than ten thousand outstanding shares, and four of them have less

than one thousand outstanding issues. Due to the small number of shares outstanding,

*All opinions expressed in this paper represent the authors personal views and thus should not be interpreted

as the Korea Capital Market Institutes ofcial position. Tel: 02-3771-0833, E-mail: [email protected]


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46 2011 Vol. 3, No. 2

these preferred stocks are prone to volatile price movements, sometimes reaching price

levels that are impossible to explain.

The trading volume of the preferred stocks is very low compared with the totalmarket volume, accounting for only 0.54% of the total during January 2009 through

September 2010. The daily average trading volume of the preferred stocks is only 3.04%

of the daily average trading volume of the market. Out of the total preferred stocks,

about 58% of stocks have less than ten thousand daily trading volume. The daily trading

volume of 11 stocks among them stands at less than 100 shares.

The low trading volume can cause distortions in price patterns, where the price of

the preferred stocks sometimes reaches far above the common stocks issued by the same

company. The price discrepancy ratio (PDR)1)between the preferred and the common

stock measures the extent by which the preferred stock is overvalued compared to the

common stock, and there are 32 preferred stocks whose PDR is over 100%. The average

PDR of the old-type preferred stocks2)is 78.35% while that of the new-type preferred

stocks stands at 49.5%.

The number of listed shares also seems to have a causal relationship with thePDR. The average number of listed shares for preferred stocks is 2.8 million shares,

whereas the average for the preferred stocks whose PDR is over 100% stands at 310

thousand shares. There are even 20 preferred stocks with less than 50 thousand shares

outstanding, and their PDR is surprisingly high at 14,000%.

1) Price discrepancy ratio = [(common stock price preferred stock price)/common stock price] x 100.

2) The old type refers to the preferred stocks issued before the Commercial Act revision of 1996. The revision

rendered the issue and dividend policy of preferred stocks more in line with the stockholders interest. The

revised law requires stricter dividend policy and under the revision, preferred stocks lose the preferred status

after some time. The old-type preferred stocks do not have any conversion options or required dividendpolicy.


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Explaining the Price Anomaly of KRX Preferred Stocks

2. Problems with preferred stocks

The KRX carries out market liquidity monitoring in order to warn investors of the

danger of low liquidity and its constraints. Since March 2007, KRX publicizes liquidity

related indicators for stocks with low liquidity in the KOSPI market. The criteria used

for the liquidity indicator includes the number of days traded, trading value, price

continuity, and the bid-ask spread. For preferred stocks, the trading value criterion is

left out, reecting the tepid trading nature of preferred stocks. Up to the second quarter

of 2010, there were 78 stocks that showed 2% or more bid-ask spread, and of those 71

were preferred stocks. In a similar manner, of the 70 stocks whose price continuity was

less than 70%, 62 were from preferred stocks.

The KRX also issues investment watch and investment warning lists to protect

individual investors. The KRX audit committee designates stocks that are prone to

excessive speculation or price manipulation in order to warn investors and to prevent

market distortion. There were 2,061 investment watch issues during 2009 through

September 2010 with 27% being issued to the preferred stocks. The investment warning

is for stocks whose prices overshoot abnormally and cause investor confusion andlosses. During the same period, there were 69 cases of investment warning and 39.1%

of them were directed to the preferred stocks.

The distortion in market prices of preferred stocks can lure speculative investors

to this sector of the market, which can further alienate the price movement from the

parent companies common stocks and their fundamental values. Although preferred

stocks do not occupy a signicant portion of the market in terms of number of issues

or capitalization, the price movements and deteriorated market quality of that section

can result in loss of condence towards the overall market. It is therefore imperative

that new rules for listing and maintenance requirements for preferred stocks should be

set. The KRX currently does have listing and maintenance requirements for common

stocks that pertain to their trading volume and the number of shares listed, but not for

preferred stocks.


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II. Empirical Analysis on the Price Anomaly

1. The relationship between price anomaly and liquidity

An empirical analysis is performed in order to establish an empirical relationship

between low liquidity and the abnormal prices of preferred stocks. The data covered

here includes market end prices, trading volumes, and trading values of both common

and preferred stocks that are listed on the KRX KOSPI market. The data period is

January 2000 to November 2010, while stocks with certain specications, as outlined

below, are excluded for analytical convenience without affecting the robustness of the

outcome.

Since most of the abnormal prices originate from the old-type preferred stocks,

the new-types are excluded.

The total market capitalization of the new-type stocks is just 13% of the total

preferred stocks.

The new-types differ signicantly in terms of requirements about the minimum

dividend yield, accumulated dividend payouts, conversion to common stocks,

etc. and are more geared towards the intrinsic characteristics of what preferred

stocks should achieve both in terms of investor interests and corporate nance

policy.

When multiple preferred stocks are issued from the same entity, only the one

with highest liquidity is included.

The prime variable of interest is the relative price of a companys preferred stock to

common stock. The purpose of the analysis is to determine which liquidity variables

have statistical signicance in explaining the relative movements of preferred stocks

prices. The null hypothesis is that the lower the market liquidity, the higher the relative

prices. The relevant explanatory variables in the analysis are the preferred stock volume

over the common stock volume, and the preferred stock traded value over the common

stock traded value. However, since the trade value is calculated by multiplying the

trading volume with the price, the relative price of preferred over common stocks are


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included in both sides of the equation, resulting in an endogeneity problem. Therefore,

the common stock price is used to calculate the traded value instead of the preferred

stocks price, and we will call the resulting variable the adjusted preferred stock traded

value.

All of the variables are measured daily, and based on the daily data, the annual

average is calculated. Observation numbers totaling 1,167 are assigned for each of the

113 companies. For each observation number, the corresponding variables are assigned

as described below. The number of resulting panel data, therefore, becomes 10,503 in

total.

Preferred stock price: psprice

Common stock price: csprice

Preferred stock trading volume: psvol

Common stock trading volume: csvol

Preferred stock traded value: psamount

Common stock traded value: csamount

Relative price of preferred stock: pcratio

Relative trading volume of preferred stock: pcvolratio

Adjusted preferred stock traded value: cpamount

2. Basic statistics

Basic statistical measures in Table 1 for the variables of interest reveal severalproperties. If we examine the minimum, maximum and the median value for the

pcratio variable, we see extremely large variations. The minimum value is 0.256,

whereas the maximum is 1,237. The fact that the median value is 0.603, which is far

less than the mean value, indicates that the distribution of the pcratio is right-skewed.

The right skewness also applies to the remaining variables, pcvolratio, psamount, and

cpamount. To prevent the values on the right side of the distribution from affecting the

results of correlation calculation and the least squares estimation, all of the variables


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are log-normally transformed. The log normal transformation also ameliorates the

problems of unreliable inference when heterogeneity is observed in the error term.

Table. 1 Basic statistics for the variables

(Unit: multiple, million won)

Mean Standard Deviation Minimum Median Maximum

pcratio 10.651 65.501 0.256 0.603 1,236.291

pcvolratio 0.087 0.416 0.000 0.026 13.136

psamount 451 2,431 0.02 41 42,883

cpamount 824 4,548 0.00 54 86,195

3. Mean analysis

To establish an average relationship between the liquidity and the relative price of

the preferred stocks, the observations are grouped into three panels: trading volume,

traded value, and adjusted traded value.

Each panel is sub-divided into ve sequential ranges, where the rst range containsthe lowest 20% values for the reference liquidity variable and the fth range contains

the highest 20% values.

In Table 2, the relative trading volume of the preferred stock, pcvolratio is used as

the liquidity criterion and the mean value of pcvolratio and pcratio is compared within

the same range. We can observe that on average, as the value of pcvolratio increases,

the value of pcratio falls. This indicates that there is a reverse relationship between the

trading volume of a preferred stock and its relative price against the common stock.

Smaller relative liquidity, measured in terms of trading volume, seems to be associated

with higher relative prices for preferred stocks.


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Table 2. Mean value analysis for pcvolratio

Reference Variable:pcvolratio

Total 1,167 Number of Panels

Sub-GroupObservations

Mean Valuepcvolratio pcratio

Range 1 (Lowest 20%) 233 0.0033 19.290

Range 2 233 0.0118 12.974

Range 3 233 0.0275 11.303

Range 4 233 0.0630 6.010

Range 5 (Highest 20%) 235 0.3284 3.734

t-test 5.59* -2.79*

Note: * indicates the signicance level of 1% for the test of difference in mean values.

The same mean value analysis can be performed utilizing two additional reference

variables for liquidity, namely the preferred stock traded value, psamount, and the

adjusted preferred stock traded value, cpamount. Table 3 and 4 describe the outcome.

Table 3. Mean value analysis for psamount

Reference Variable:psamount

Total 1,167 Number of PanelsSub-Group

Observations

Mean Value

psamount pcratio

Range 1 (Lowest 20%) 233 3,972,503 31.265

Range 2 233 16,152,640 16.953

Range 3 233 43,908,751 2.659

Range 4 233 121,558,494 1.831

Range 5 (Highest 20%) 235 2,055,735,319 0.631

t-test 6.12* -4.29*


In Table 3, we also observe that preferred stocks with smaller traded values are

associated with higher relative prices. The mean difference of pcratio is also signicant

at the 1% level.


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Table 4. Mean value analysis for cpamount

Reference Variable:cpamount

Total 1,167 Number of Panels

Sub-GroupObservations

Mean Valuecpamount pcratio

Range 1 (Lowest 20%) 233 1,988,718 50.276

Range 2 233 17,863,488 1.140

Range 3 233 56,874,414 0.832

Range 4 233 183,302,405 0.588

Range 5 (Highest 20%) 235 3,835,468,520 0.504

t-test 6.11* -5.43*


Table 4 used the price of common stocks to calculate the traded value of preferred

stocks in order to address the problem of endogeneity. The result, nonetheless, is quite

similar to the result in Table 3: the lower the traded value, the higher the relative price

of preferred stocks.

The results of the three tables do indicate that low liquidity is closely related

with the higher relative price for preferred stocks. However, there seems to be somequalitative difference in the relationship, depending on whether one uses the relative

trading volume or the absolute trading value. We notice in Table 1 that even when the

relative trading volumes are in the highest range, the preferred stocks are overpriced

by a factor of 3.734. However, for the traded value, whether we use the preferred stock

or common stock price, the high trading amount is associated with more normal

preferred stock prices. The highest 20% group in Table 2 shows an average pcratio of

0.63, which is close to the median value of 0.603, indicating that the traded amount

may be a more representative liquidity variable in explaining the abnormal price of

the preferred stocks.


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4. Regression analysis

Linear regression is performed to ascertain that liquidity variables do have

explanatory power over the preferred stock price anomaly. The two liquidity variables

utilized are the relative trading volume of the preferred stock over common stock,

pcvolratio, and the adjusted traded value of the preferred stock, cpamount. As

mentioned before, the variables are transformed through a logarithm operation in

order to account for the skewness in the distribution of the variables. The regression

model is given as

ln(pcratioi)= + 1ln(pcvolratioi)+ 2ln(cpamounti)+ ui

The results of the estimation are given in Table 5.

Table 5. Regression results for the relative price of preferred stocks

Coefcient Standard Error t-stat

Constant 7.402 0.196 37.86*

ln(pcvolratio) 0.092 0.017 5.40 (5.63)*ln(cpamount) -0.401 0.009 -42.26 (-27.21)*

R2= 0.611

Note: * indicates signicant at 99% condence level, while the t-stat in the parenthesis is the White (1980)

adjustment for heteroskedasticity in the error term.

The results show that both liquidity variables are signicant in explaining the

higher relative price of preferred stocks. However, the traded value variable has a larger

coefcient with the correct intuitive sign and larger t-stat than the relative tradingvolume. These results coincide with the earlier mean value analysis in identifying the

traded value as the relevant liquidity variable associated with the price anomaly of

preferred stocks.


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III. Conclusion and Implications

The main purpose of this paper is to evaluate the trading volume and the traded

value as a useful indicator of liquidity in explaining the spikes in preferred stock prices

and to provide guidelines in case of adopting rules to delist sub-standard preferred

stocks from the exchange market for investor protection purposes.

The results indicate that the traded value has a high degree of explanatory power

on the relative preferred stock prices. When the traded value of certain preferred

stocks is small, it is prone to exhibit an irregular price pattern over its common stock

counterpart. On the other hand, when there is a higher relative trading volume for apreferred stock, the relative price becomes higher as well. The latter result seems to

indicate that a higher trading volume in preferred stocks may be a sign of a speculative

trading pattern.


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Reference

White, H., 1980, A heteroskedasticity-consistent covariance matrix estimator and a

direct test for heteroskedasticity, Econometrica, 48, 817-838.

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