Academic journal article Journal of Economics and Finance

The Linkage between the U.S. "Fear Index" and ADR Premiums under Non-Frictionless Stock Markets

Academic journal article Journal of Economics and Finance

The Linkage between the U.S. "Fear Index" and ADR Premiums under Non-Frictionless Stock Markets

Article excerpt

(ProQuest: ... denotes formulae omitted.)

1 Introduction

American depository receipts (ADRs) have become one of the most important financial instruments for companies from emerging economies to overcome capital barriers by accessing U.S. stock markets. Additionally, ADRs have been commonly used as convenient instruments for international diversification as they are available in the U.S. and denominated in U.S. dollars. Consequently, the breadth and availability of ADRs has been constantly increasing as more firms continue cross-listing their shares in the U.S.1

According to the law of one price (LOP), the ADR price must equal the price of the underlying security after adjusting for the ADR ratio and exchange rate. However, there seems to be a systematic mispricing, or ADR premium, in the ADR market. We attempt to identify the sources of the ADR mispricing. One of the most important limitations to calculate the ADR premium is the lagged effects. For instance, there is a significant timing difference between Asian and North American stock exchanges. However, Kim et al. (2000) find that the effect of stock markets and exchange rate fluctuations on ADR prices is mostly completed during the same calendar day. Unlike their Asian and European counterparts, Latin American countries share a high and homogeneous linkage to the U.S. financial markets. In addition, simultaneous trading hours also have the beneficial effect of reducing the likelihood of lagged effects. Our findings on ADRs from Latin American countries can be extended to other emerging market ADRs. The outstanding growth of emerging economies has been reflected in the high number of ADR programs initiated in recent years. Figure 1 depicts the number of exchange-traded ADR programs by region and indicates that Latin American countries comprise a substantial portion of the ADR market.

Using 69 ADR programs from Argentina, Brazil, Chile, and Mexico over the period from January 1995 to May 2009, we test whether investor sentiment has a significant impact on ADR premiums. We use the Volatility Index (VIX) as a proxy for investor sentiment. High levels in the VIX indicate that investors are likely to have pessimistic expectations about the U.S. stock market.2 We define the ADR premium as the disparity between the ADR price and the price of the underlying share, after adjusting for the corresponding exchange rate and ADR ratio.3 In addition to the aforementioned factors, we control for the domestic and the U.S. stock market indices which are widely documented as relevant determinants of ADR prices in the literature (Kim et al. 2000; Fang and Loo 2002; Bin et al. 2004; Bae et al. 2008; Alhaj-Yaseen 2011; Esqueda and Jackson 2012). We find a negative and significant relationship between investor sentiment and ADR premiums. The deviations from the LOP in ADRs can be partially explained by investors' fears about the future of the stock market, as evidenced by changes in the volatility index. Additionally, current U.S. stock market behavior is also a relevant pricing factor. We conclude that investors can improve their hedging strategy by incorporating the lagged values of the volatility index in determining ADR prices.

This paper contributes to the existent literature in the following ways. First, we relate ADR premiums to the volatility index, which measures investors'"fear" about future stock market movements. To test the statistical inference between ADR premiums and investor sentiment, we use a generalized autoregressive conditional heteroskedasticity in mean model (GARCH-M) and acknowledge the potential conditional variance of the ADR premium in our sample period due to country events such as currency depreciations. Second, we control for the relevant factors in ADR pricing by comparing the response of ADR premiums to changes in the volatility index. The results have important implications for constructing country portfolios by observing investors' preferences. …

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