The Effect of Eurozone Crisis on Eurozone ADR Pricing

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INTRODUCTION

The European sovereign debt crisis, also referred to as the Eurozone crisis or euro crisis, has been ongoing for more than two years, constantly making headlines in major newspapers around the world. A series of events mark the official start of the long-going crisis. In the wake of the Dubai sovereign debt crisis in November 2009, concerns mounted over some euro countries' debt issues. On November 30, 2009, Papandreou, the new prime minister of Greece, admitted that the Greek economy is in "intensive care" (Timeline: Greece's journey to the edge of euro, The Guardian, by Graeme Wearden, Tuesday 21 June 2011). On December 8, 2009, Fitch cut Greece's long-term debt from A- to BBB+. Before the EU summit on December 10, Greece government admitted that their debts had mushroomed to 300 billion euros (450 billion dollars), 113 percent of Greek GDP, almost doubling the Eurozone limit of 60 percent. On December 16, Greece suffered another downgrade by Standard & Poor's to BBB+. After more than two years with rounds of bailouts, austerity measures, and debt haircut, the European sovereign debt crisis is still ongoing, severely affecting most of the countries in the euro zone. The five countries of Greece, Portugal, Ireland, Italy, and Spain, often referred to as "PIIGS", took the biggest hit.

This study examines the determinants of Eurozone originated American Depositary Receipts (ADRs) returns during the euro zone crisis. An ADR is a security that represents underlying shares of a foreign company but trades in the U.S market. ADRs provide U.S. investors many advantages over trading directly the underlying foreign stocks. Like U.S. stocks, ADRs are denominated and quoted in U.S. dollars, and dividends are paid in U.S. dollars after the custodian bank collects the foreign dividends and converts them to U.S dollars. The foreign firms are also subject to full regulation and disclosure requirements for their ADRs to be traded on major U.S. exchanges. However, ADRs bear more risks than U.S. stocks. First, unlike U.S. stocks whose investors face exchange rate risk due to company's operational and financial activities, ADRs has an extra facet of exchange rate risk directly borne by investors. Because ADRs track the shares in the foreign country, if a country's currency value changes, the change will trickle down to ADRs, affecting ADR returns. Furthermore, ADRs are subject to home country risk. In a perfect market that is frictionless and fully integrated, equity returns, including those of ADRs, U.S stocks, and underlying foreign stocks, should be determined solely by their covariance with the world factors, and therefore local risk should not factor in. However, as suggested by prior literature (e.g., Jiang, 1998; Choi and Kim, 2000; and among others), local factors do contribute to ADR pricing. Some studies (e.g., Choi and Kim, 2000; Fang and Loo, 2002) find that local factors may be more important in determining ADR returns than the U.S. Market factors, especially for emerging countries with segmented markets.

Previous literature also studies returns of ADRs during currency and financial crisis (e.g., Bin, Blenman, and Chen, 2004; Pasquariello, 2008). The Eurozone Crisis, however, is different from any prior crisis. First, the Eurozone countries, as an economic and monetary union, share a single currency, the euro, and thus their ADRs are subject to the same exchange rate movement. However, since not all the countries are affected equally by the euro zone crisis, we can still expect to observe heterogeneity in ADRs pricing due to the different country risk at the country of origin. Also, unlike countries in most of the previous crises examined, the Eurozone countries are more developed. The companies that issue ADRs are large and well-established with operations on a global scale. Many ADRs from the Eurozone are household names, such as Unilevel, Nokia, and Daimler Chrysler. An interesting question is whether these ADRs will be subject to increased local pricing as the ADRs in emerging markets (Pasquariello, 2008). …