This article was first published in the Hindu Businessline, Investment World, July 8, 2013; Co-Author: Kaushik Bhattacharjee, IBS Hyderabad.
The globalisation of the Indian stock market is reflected in India’s sophisticated institutional capacity, facilities and international practices, which have increased capital availability and market liquidity in India by attracting FIIs.
Unimpeded financial markets allowed Indian companies to cross-list in international exchanges and raise capital by issuing depository receipts and convertible bonds.
Issued by US banks (acting as custodian), ADRs are negotiable certificates that represent the ownership of shares in non-US companies. They enable US investors to invest in foreign securities and non-US investors to invest in US markets.
These instruments provide a unique opportunity to investigate interaction channels between the US and other equity markets, both in synchronous (eg. US and Canada) and non-synchronous (eg. US and India) time settings.
In synchronous settings, ideally speaking, in the absence of any frictions like capital control or illiquidity or differential tax structure, information should flow into both the markets at the same time instance.
However, in non-synchronous settings like NYSE/Nasdaq in the US and NSE/BSE in India, various issues of market efficiency such as price transmission and price discovery beckon investigation.
On any calendar day, the Indian market opens first and the US market is the last to close. Therefore, if markets are efficient, the ADRs should react to new market-wide information in India when US markets are closed and vice-versa.
If the exchange rate remains approximately constant over time, an upward (a downward) movement of the underlying assets will move up (down) the corresponding ADR’s price.
On a given calendar day, Indian markets close first. Therefore, if the two markets are fully efficient and the prices of underlying shares truly affect the prices of ADRs, then we expect that a shock from the underlying shares would be reflected in ADR prices (as well as price changes) in the same calendar day. However, a shock in the previous trading day should not affect the ADR.
Exchange rate impact
ADR prices get indirectly influenced by the INR/USD rate. For foreign portfolio investors, directly holding INR denominated shares, profits from investments in Indian markets are subject to exchange rate risk.
Movements in INR/USD rates directly affect Indian ADR prices until possible arbitrage profits, triggered by foreign exchange movements, disappear.
An upward (a downward) movement of the underlying stock coupled with an appreciation (a depreciation) in INR/USD rates will exert greater pressure on that particular Indian ADR to move up (down). However, if these two move in opposite directions with the same magnitude, the effect is netted out and the ADR price remains the same.
We find that, the way changes in ADR returns relate to changes in the S&P 500 Index, Nifty index and exchange rate differs from how ADR prices change subsequent to changes in underlying stock prices. The contemporaneous changes in Nifty index positively influence ADR returns, followed by a significant (mostly negative) price response on the following days. The exchange rate emerges as significant for some stocks at different lags. Thus, while ADRs seemingly under react to information on underlying securities and overreact to information on their own lagged values in gradual diminishing magnitude, this is not the case with market indices.
This indicates that information transmission to and from the domestic and U.S. markets is not completely efficient. It is reasonable to conjecture that besides market frictions, such as conversion fees and capital control restrictions (e.g. the famous headroom issue), the mis-pricing is due to varying expectations of investors in these two markets.