An Empirical Study of Exchange- Traded ADRs from India

Transcription

1 An Empirical Study of Exchange- Traded ADRs from India RAJESH CHAKRABARTI = I C R A B U L L E T I N APRIL SEPT. 23 Abstract Depositary Receipts have emerged as a favoured vehicle to access developed stock markets for many emerging market companies. India has been no exception. While several Indian companies have issued American Depositary Receipts (ADRs) in the 199s only a few of these securities are listed on US exchanges. We study the return and volume dynamics of these exchange-listed ADRs of Indian origin. We find that the underlying stock returns, exchange rate and market indices in the US and India together often explain less than half the movement in ADR returns. Returns and volumes also exhibit low cross-border correlations. Indian ADRs often enjoy large premiums, indicating effective market segmentation between the two countries. Finally, ADR issuance often has a temporary positive effect on the underlying stock price, but usually does not materially alter the stock s relationships with the US and Indian markets. 1. Introduction With the opening up of the financial markets, Indian companies joined the 199s worldwide rush to raise capital by issuing Depositary Receipts. While Indian companies have issued American Depositary Receipts (ADRs) since the early 199s, most of these earlier issues were privately placed. Exchange-traded ADRs of Indian origin have been a relatively recent phenomenon. Currently, there are close to 8 active Depositary Receipts of Indian origin. A dozen of them trade on US exchanges the New York Stock Exchange and the NASDAQ all issued during or after 1999 (see Table 1). This article examines their market performance. It attempts to identify the drivers of market returns of these ADRs and investigates their relationship with the underlying securities. It also studies the effect of issuance of such ADRs on the issuing company s shares in the domestic (Indian) market. ADRs are instruments issued in the United States in lieu of a non-us company s shares. They are tradable in the USA (or in another country, though usually the term Global Depository Receipt, or GDR, is This article attempts to identify the drivers of market returns of these ADRs and investigates their relationship with the underlying securities. It also studies the effect of issuance of such ADRs on the issuing company s shares in the domestic (Indian) market. = Dupree College of Management,Georgia Institute of Technology, 755 Ferst Drive, Atlanta GA 3332, USA. Tel: ; Fax: ; rajesh.chakrabarti@mgt.gatech.edu 29

2 I C R A B U L L E T I N APRIL SEPT..23 TABLE 1 ADRs of Indian Origin Trading on Major US Exchanges Company Exchange Effective Date Ratio (ADR : Shares) Dr. Reddy s Laboratories Ltd. NYSE 11/4/21 1:1 HDFC Bank Ltd. NYSE 25/7/21 1:3 ICICI Bank Ltd. NYSE 31/3/2 1:2 ICICI Ltd. (now merged) NYSE 1/11/1999 1:5 Infosys Technologies Ltd. NASDAQ 16/3/1999 2:1 Mahanagar Telephone Nigam Ltd. NYSE 28/9/21 1:2 Rediff.Com India Ltd.* NASDAQ 19/6/2 2:1 Satyam Computer Services NYSE 14/5/21 1:2 Satyam Infoway Ltd.* NASDAQ 1/1/1999 4:1 Silverline Technologies NYSE 19/6/2 1:2 Videsh Sanchar Nigam Ltd. NYSE 15/8/2 1:2 Wipro Ltd. NYSE 24/1/2 1:1 * Trading solely on US markets, not listed in India. Source: Bank of New York website. used for Depositary Receipts outside the USA) though the company itself is not listed on a US exchange. Depositary Receipts thus provide companies in emerging economies with a way of tapping industrialised markets, particularly the US market, for equity capital arguably the least expensive way to make a company s equity available to foreign investors. The 199s witnessed an explosion in the number of ADRs issued and the amount of capital raised by companies mostly from developing countries. (See Box 1 for a brief description and history of ADRs.) Several factors are likely to influence the dynamics of ADR prices and volume. Since ADRs are dollar-priced entitlements to foreign shares, movements in their prices and returns are naturally expected to BOX 1: American Depository Receipts Nature and Brief History 3 American Depositary Receipts (ADRs) are instruments representing foreign (non- US) stocks (or debt) that are tradable in the USA. They serve as evidence of the original share being held in an American bank, known as the custodian. They are quoted and pay dividends in US dollars. Depositary receipts can be sponsored or unsponsored. Most ADRs trading today and all from India belong to the former category. Sponsored ADRs are issued by a depositary appointed by the company under a Deposit Agreement. Bank of New York is the most frequent sponsor of ADRs issued by Indian companies (both exchange-traded and others) followed closely by Citibank, Deutsche Bank and Morgan Stanley. There are at least three distinct levels of sponsorship. For a Level-I sponsored ADR, the issuing company does not have to comply with the US accounting procedures or the disclosure requirements mandated by the US Securities and Exchange Commission (SEC). Such ADRs are tradable in the US over-the-counter

3 (OTC) markets. In order to be listed on an American stock exchange, Level-II sponsorship is necessary and Level-III sponsorship is required if the issuing company is raising money in the US market. ADRs can also be privately placed in the USA under what is known as the Rule 144A (they are called RADRs and can be traded on PORTAL, a screen-based market) or sold to non-us investors under Regulation S. A vast majority of Indian ADRs belong to these categories and do not trade on American exchanges. The main benefits of ADRs include easier cross-border trading and settlement and minimum transaction costs. They help American investors diversify internationally, and foreign companies to tap the US financial markets in a relatively inexpensive way. A public offer of ADRs usually took about 1 weeks for Level-I and II sponsorship and 14 weeks for Level-III sponsorship while private placement could be achieved in 16 days in Transaction costs ranged from less than US$25, to about US$2 million for public issues and between US$25, and US$5, for private placement*. Though the first Depositary Receipts were created by J.P. Morgan, way back in 1927, and there were several unsponsored ADRs in the 195s, the ADR market began to show moderate activity in the 197s and 198s and virtually exploded in the 199s. In 1994 about US$2 billion was raised through the DR market. Out of this, about US$11 billion was raised by Level III Depositary Receipts representing an increase of 633% from 199 and over US$8 billion was raised using 144A Depositary Receipts, an increase of over 98% over 199 (Miller (1999)). Figure 1 shows the growth of share volume and dollar volume of exchange-listed Depositary Receipts during the late 199s. I C R A B U L L E T I N APRIL SEPT. 23 FIGURE 1 The Growth of ADRs during the late 199s Share Volume (Billions o Share Volum e Dollar Volum e Dollar volume (US$ Bi Years Source: Bank of New York (21). *1995 figures. Source: Miller (1999). 31

4 I C R A B U L L E T I N 32 APRIL SEPT..23 In this study we explore various aspects of the returns and prices of ADRs of Indian origin.... We research the effects of ADR issuance on the returns of the underlying stocks and their relationship with the Indian and the US markets. be affected by those in the underlying shares and the relevant exchange rate. The existence of a difference between the ADR price and dollar price of the underlying stocks the premium or discount then reflects two things. Firstly, the no-arbitrage condition does not hold, and secondly, the factors driving the ADR returns are potentially different from those driving the returns on the underlying stock. The host country (here US) market becomes the natural candidate for such a factor, since American investors, who are obviously affected by the movements in the US market, trade ADRs. Thus, the US market movements constitute a usual suspect in the study of ADR prices and returns. Finally, to the extent that ADRs provide opportunities for international exposure to US investors, the movements of a suitable Indian index are also likely to be relevant for understanding the price dynamics of ADRs. These relations are reasonable for all ADRs including those from India. Given the fact that international capital mobility is less than perfect between India and the US, we would expect the existence and persistence of premium/discounts for Indian ADRs. In this study we explore various aspects of the returns and prices of ADRs of Indian origin. We explore the dynamics of ADR returns and seek to explain them with the variables we would a priori expect to affect them. We study the nature of premiums enjoyed by these ADRs and their determinants. We examine the extent of crossborder connection in trading volume and market return between the ADRs and their underlying stocks. Finally we research the effects of ADR issuance on the returns of the underlying stocks and their relationship with the Indian and the US markets. 2. Related Research The past few years have seen several papers researching different aspects of Depositary Receipts. Some have even focused on Indian Depositary Receipts, though exchange-traded ADRs from India have not been the focus of much research, largely because they have been a relatively recent phenomenon. Nonetheless, the existing research does bring out some important facts about ADRs in general and Depositary Receipts from India in particular. The issue of relative pricing of stocks in segmented markets, i.e. in the US markets through ADRs and in India, has received some attention. Returns on GDRs (Depositary Receipts existing both in the US and other countries) from India between 1992 and 1998 and the returns on the corresponding stocks in India have been examined to better understand this relationship. 1 It is observed that these GDRs enjoy a considerable premium over their underlying stock price. This is particularly noteworthy since during the period the Indian market was open to foreign institutional investors and the existence of such pre- 1 See Jithendranathan et al (2).

5 mium appears to have presented arbitrage opportunities. The very existence of such premiums, therefore, has been viewed as evidence of de facto market segmentation between India and the countries where they are traded. 2 Also the GDR returns have been found to be influenced by not just Indian returns but particularly market returns in the host country a widespread phenomenon in the world of ADRs. The causes for such market segmentation lie in the extant barriers to cross-border investment involving India. There are limits to foreign ownership of domestic stocks, investment in Indian bourses is restricted to registered foreign institutions only and Indians cannot trade in ADRs. All these restrictions add to the transaction costs of cross-border arbitrage and make it impossible beyond a point. Nevertheless, it is difficult to accept that premiums as high as 15% can be caused solely by higher cross-border transaction costs. Behavioural factors may also play a role in cases of very large premium and in the variation of premiums across different ADRs from the same country. Several studies have also investigated the effect of ADR issue on underlying stock returns. The accumulated evidence appears to suggest that ADR issuance increases stock prices permanently probably by reducing cost of capital and increasing liquidity. This has been generally found to be true for ADRs from a large set of countries. 3 In particular, GDRs from India between 1992 and 1998, operating under Regulation S and SEC s Rule 144A, appear to exhibit these tendencies as well. 4 Another area that has received considerable attention is the effect of ADRs on the underlying stock s relationship with the local and the US markets. The local market beta (the sensitivity of the stock s return to the local market return) is generally found to decline with ADR listing, but the rise of the US market beta of the stock is often not significant. 5 Exchange-traded ADRs are by far the most important foreign securities from India with enough liquidity to provide reliable price and return information. However, because they are both fewer and of much more recent origin, there has been relatively less analysis of the market performance of these securities and its determinants. Nonetheless, the relationship between these exchange-traded ADRs and their underlying stocks has recently been explored. It has been documented that as expected, the returns on stocks and their ADRs have a strong correlation in prices in the two markets as well as indications of causality in both directions between the two markets. 6 The present paper looks at exchange-traded stocks and asks a I C R A B U L L E T I N APRIL SEPT. 23 Itisdifficultto accept that premiums as high as 15% can be caused solely by higher cross-border transaction costs. Behavioural factors may also play a role in cases of very large premium and in the variation of premiums across different ADRs from the same country. 2 This is not very surprising though. The very existence of ADRs is in order to overcome certain barriers in cross-border investments. If US investors could costlessly trade foreign stocks, then ADRs would have been redundant. 3 See Miller (1999). 4 See Pinegar and Ravichandran (22). 5 See Jayaraman et al (1993), Karolyi (1998) and Foerster and Karolyi (1999). 6 See Hansda and Ray (23). 33

6 I C R A B U L L E T I N 34 APRIL SEPT..23 The focus here is more on the analysis of the returns and trading volume rather than prices. Besides, the present study goes beyond establishing the expected relationship between the two markets to assess the extent and importance of that relationship. The effects of ADRs on the underlying stock returns are also explored. different set of questions. The focus here is more on the analysis of the returns and trading volume rather than prices. Besides, the present study goes beyond establishing the expected relationship between the two markets to assess the extent and importance of that relationship. Finally the effects of ADRs on the underlying stock returns are also explored. 3. The analysis of ADR prices and returns Ten Indian-origin ADRs are actively traded on American markets and also have the company s stock publicly trading in India. We consider these ten stocks and their ADRs in our study. The Appendix discusses the data and its sources. Table 2 provides some descriptive statistics of the data. TABLE 2 Descriptive Statistics of the Data Mean Median Maximum Minimum Std. Dev. Rs Rs Rs Rs Rs Stocks HDFC ICICI ICICI Bank Infosys MTNL Dr. Reddy s Lab Silverline Tech Satyam Comp Serv VSNL Wipro US$ US$ US$ US$ US$ ADRs HDFC ICICI ICICI Bank Infosys MTNL Dr. Reddy s Lab Silverline Tech Satyam Comp Serv VSNL Wipro Indices BSE_NATIONAL BSE_SENSEX SP NASDAQ A. What determines ADR returns? To start our empirical investigation of ADRs we enquire how much of the variation in daily returns can be explained using variables that we a priori believe to be determining them.

7 It is noteworthy that ADRs are, in a sense, derivative securities, i.e. assets that derive their value from the value of other financial assets. Abstracting from transaction costs and restrictions on cross-border investment, it is possible to arbitrage ADRs with the underlying stocks. Thus in a no-arbitrage sense, exchange rate changes and return on the underlying stock together should be able to explain ADR returns completely. However, previous research has suggested that returns in the market where the ADR trades (i.e. the US market) affect the returns on the ADRs. This is because, to the US investors, ADRs provide an easy way to achieve international diversification. Consequently, ADRs are also related to US market returns. Finally, it may be argued that the return on an ADR from a particular country is also affected by the returns on the market of its origin as well. 7 Based on these observations, we run regressions of the daily returns on the Indian-origin ADRs on the return on the underlying stocks, the change in US-India exchange rate, the BSE National Index as well as two important stock indices from the USA the SP 5 and the NASDAQ. Figure 2 shows the R 2 of these regressions for the ten stocks under consideration. The proportion varies from about 5% for HDFC Proportion of variation explained FIGURE 2 The Proportion of Variation in ADR Returns Explained (R-squared) I C R A B U L L E T I N APRIL SEPT. 23 Previous research has suggested that returns in the market where the ADR trades (i.e. the US market) affect the returns on the ADRs. This is because, to the US investors, ADRs provide an easy way to achieve international diversification. HDFC ICICI ICICI Infosys MTNL Dr. Silver- Satyam VSNL Wipro Bank Reddy s line Computer Services Companies Consequently, ADRs are also related to US market returns. 7 Home country factors may affect the return on the underlying stock and, in turn, that on the ADR. In a perfectly integrated market the effects on the ADR returns should exactly correspond to the effects on these two variables and the premium should stay unperturbed. However, often owing to restricted capital mobility the effects do not match up perfectly, and the premium on the ADR may get affected too. 35

8 I C R A B U L L E T I N 36 APRIL SEPT..23 The fact that Indian stock markets are open not to individual foreign investors, but only toinstitutional investors, makes international arbitrage with ADRs difficult. This lack of arbitrage opportunity would substantially weaken the relationship between the ADR returns and the dollar returns on the underlying stock. to slightly over 6% for Satyam Computer Services. The average R 2 is slightly over 32% and the median is slightly over 3%. In 8% of the cases, less than 5% of the variation is explained and in half of the cases less than a third of the variation is captured by the variables identified. One is, therefore, challenged to speculate on the causes of this low explanatory power of the variables considered. It may be argued that the fact that Indian stock markets are open not to individual foreign investors, but only to institutional investors beyond a certain size registered with Indian regulatory authorities, makes international arbitrage with ADRs almost an impossibility. This lack of arbitrage opportunity would substantially weaken the relationship between the ADR returns and the dollar returns on the underlying stock (the Rupee returns and the changes in the exchange rate). B. The premium on ADRs Like all ADRs (and country funds too for that matter) Indian ADR prices are almost never equal to the price of Indian shares they represent, after correcting for the exchange rate. Derivative instruments like ADRs trade at a premium or discount in relation to their underlying assets within the band of transaction costs so that there is no arbitrage opportunity. In the case of ADRs, however, the transaction cost barrier necessary to prohibit arbitrage is difficult to determine a priori, particularly in the light of restrictions to cross-border investment, as is the case in India. Table 3 presents the descriptive data about premiums on ADRs. Premiums are calculated as the percentage excess of price of the ADR over the Indian market value of the number of shares it represents converted to US dollars. Figure 3 presents the sketches of the daily premiums over time. All stocks under study enjoyed a statistically significant premium on an average. Infosys and HDFC enjoyed the most spectacu- TABLE 3 Descriptive Statistics of the ADR Premiums Mean Median Maximum Minimum Std. Effect Dev. of US markets HDFC 6.65% 61.3% 96.28% 41.96% 7.16%.15 ICICI 25.48% 22.27% % -5.67% 19.56%.37 ICICI Bank 15.38% 1.7% 8.74% -1.62% 18.37%.5 Infosys 67.97% 61.95% % 11.98% 28.68%.57 MTNL 1.89%.9% 24.12% -7.9% 4.71%.21 Dr. Reddy s Lab 4.4% 1.34% 33.21% % 7.74%.16 Silverline Tech 1.3% -.89% 37.25% -21.2% 1.22%.27 Satyam Comp Serv 12.18% 12.23% 44.59% -2.64% 5.32%.38 VSNL 1.67% -.52% 55.91% -1.2% 8.2%.24 Wipro 3.24% 2.24% 31.54% -8.5% 5.37%.3

9 lar premiums. The premium on Infosys ranged between 12% and a whopping 194% while that on HDFC ADRs never fell below 4%. In terms of market performances for ADRs, HDFC seems to have maintained a very stable and high premium. The premium on Infosys ADR, on the other hand, has closely tracked the fortunes of the technology-heavy NASDAQ index in the United States. Clearly, the excitement about Infosys in the US market was closely related to that market s fascination with technology stocks till 2 and Infosys ADRs suffered the same fate as other technology stocks after the market meltdown. What is, however, particularly worth noting is the fact that the Infosys stock price itself is very highly correlated with NASDAQ a correlation level of close to.75. One would assume that all the NASDAQ-related technology effects of Infosys would already be taken care of in its stock price. The fact that on top of this stock price, the premium too has a very high correlation with NASDAQ about.63 suggests that Infosys ADRs are even more closely related to the index than the Indian markets. Another striking feature is the relatively lacklustre performance of another feted Indian IT stock Wipro. Compared to high-flyers like Infosys and HDFC, Wipro has exhibited a rather modest show in terms of its premium. Wipro s premium has averaged a little over 3% over the entire period ranging from a discount of about 8.5% to a premium of 31.5%. Much of the astronomical premiums on Infosys comes from the heydays of tech stocks, a boom that Wipro has partially missed out, being over a year-and-a half behind Infosys in bringing out its publicly traded ADR. But even for the period when both the ADRs were trading, the average premium on Infosys is over 18 times that of Wipro. Given that the two stocks operate in similar environments and have a correlation of.87 in prices and.64 in returns, such a huge difference in their premiums as well as the extremely low correlation between the two premiums.6 suggest that the explanation lies more on investor perception and behaviour than fundamentals. Infosys appears to have been much more successful than Wipro in projecting itself in the US markets as the Microsoft of India, creating a large demand for its ADRs among US investors. Financial sector ADRs, like those of HDFC, ICICI and ICICI Bank, have enjoyed high premiums. As an industry probably the financial companies have been able to command the highest and most stable premiums among the Indian companies. How much of these premiums are explained by the movements in the US markets? The last column of Table 3 lists the R 2 of the regressions of the premium of the different ADRs on the SP 5 and NASDAQ. Econometrically speaking, given the fact that these two factors are correlated and integrated, we cannot put too much faith in the coefficient estimates themselves but the R 2 of these equations still serve as reliable measures of the effect of US markets on the premiums on Indian ADRs. The figures range from a minimum of about 3% for I C R A B U L L E T I N APRIL SEPT

10 I C R A B U L L E T I N APRIL SEPT FIGURE 3A Percentage Premiums on ADRs /16/99 12/21/99 9/26/ 7/3/1 4/9/2 1/14/3 PREMIUM_HDFC 3/16/99 12/21/99 9/26/ 7/3/1 4/9/2 1/14/3 PREMIUM_ICICI Comparing US market ADR returns with the same-date returns in India on the corresponding stocks would provide us with an idea of the relationship between the two markets /16/99 12/21/99 9/26/ 7/3/1 4/9/2 1/14/3 PREMIUM_MTNL /16/99 12/21/99 9/26/ 7/3/1 4/9/2 1/14/3 PREMIUM_REDDY /16/99 12/21/99 9/26/ 7/3/1 4/9/2 1/14/3 PREMIUM_VSNL Wipro to a maximum of 57% for Infosys with a median value of about 27%. In brief, US market movements do have a big role in explaining the premiums on exchange-traded ADRs of Indian origin. 38 C. The Relationship between Indian and US market returns What is the relationship between returns on stocks in the Indian markets and the returns on their ADRs in the US markets? To answer this question we investigate if US ADR markets reacted systematically to Indian markets on a day-to-day basis. Given the time zone difference between the two countries, trading in the Indian market is over before US markets open for the same date. Thus comparing US market ADR returns with the same-date returns in India on the corresponding stocks would provide us with an idea of the relationship between the two markets.

11 FIGURE 3B Percentage Premiums on ADRs I C R A B U L L E T I N APRIL SEPT /16/99 12/21/99 9/26/ 7/3/1 4/9/2 1/14/3 PREMIUM_ICICIBK 3/16/99 12/21/99 9/26/ 7/3/1 4/9/2 1/14/ PREMIUM_INFY /16/99 12/21/99 9/26/ 7/3/1 4/9/2 1/14/3 PREMIUM_SILVR 3/16/99 12/21/99 9/26/ 7/3/1 4/9/2 1/14/ PREMIUM_SYCS /16/99 12/21/99 9/26/ 7/3/1 4/9/2 1/14/3 PREMIUM_WPRO Table 4 presents the correlations between daily returns on ADRs and the daily return on the underlying stocks and the exchange rate. The return on the exchange rate is defined here as the depreciation of the Indian rupee against the US dollar. Given that ADRs are essentially securities certifying the underlying shares, the correlations in returns appear to be generally on the lower side. They range from.18 for HDFC to.75 for Satyam. The relationship with exchange rate changes also appears to be rather tenuous. The expected sign here is negative. The highest absolute value is.33 while the average is.1. Evidently the impact of the Indian market return varies considerably across stocks. These results confirm the generally low explanatory power of the variables in Figure 2. Now that we know that ADRs do not move exactly in step with 39

12 I C R A B U L L E T I N APRIL SEPT..23 The low explanatory power of share trading volume on ADR volume indicates the fact that much of ADR trading is motivated by local factors in the country they are traded in. TABLE 4 Characteristics of Daily Returns of ADRs Correlation with Average Excess Underlying Stock Exchange Rate Return HDFC ICICI ICICI Bank Infosys MTNL Dr. Reddy s Lab Silverline Tech Satyam Comp Serv VSNL Wipro Average the underlying stocks, an alternative way of examining the relationship between these two returns is to study the excess return of the ADRs over the underlying stocks. The last column of Table 4 presents the average excess returns for the different stocks during the period under consideration. Without exception, they are essentially zero. Thus while there is considerable randomness in the returns of ADRs, there is no systematic bias or over- or under-reaction in ADR returns with respect to the underlying stock returns. D. Trading Volume Next we look at the relationship between trading volume of ADRs and that of their underlying shares in India. As a first brush, we look at the correlations between the trading volumes presented in Table 5. They range from.12 to.54 with the average of.31. Only one of the ten, Infosys, has a correlation over.5. The second column of Table 5 shows the R 2 of the univariate regression of ADR volume on underlying stock volume. The average R 2 is.5. Thus, it appears that like returns, trading volumes of the underlying stocks have little explanatory power over ADR volume. The low explanatory power of share trading volume on ADR volume indicates the fact that much of ADR trading is motivated by local factors in the country they are traded in. 4 E. Effect of ADR issue on stock return Are ADR issues good news for domestic markets? In order to investigate this issue we define daily abnormal returns on a stock as the daily return on the stock less the contemporaneous return on the BSE National Index. A study of these abnormal returns gives us an indication whether Indian markets consider the issuance of ADRs a cause for

13 TABLE 5 ADR Volume and Underlying Share Volume Correlation R 2 HDFC.17. ICICI.13. ICICI Bank.12. Infosys.54.2 MTNL.22.2 Dr. Reddy s Lab Silverline Tech.42.4 Satyam Comp Serv.36.9 VSNL Wipro.46.9 Average.31.5 I C R A B U L L E T I N APRIL SEPT. 23 celebration. The consideration of abnormal returns rather than raw returns themselves captures the overall effect of the market. The cumulative abnormal returns (CAR) over 2-day periods (roughly corresponding to a month) are computed by adding these abnormal returns, going both ways from the ADR issuance date. Next the cumulative abnormal return over the 2-day period immediately preceding the ADR issuance date is compared with the average cumulative abnormal returns over the entire period. The results of this comparison are shown in Table 6 below. Table 6 gives a mixed picture. Six of the ten ADR issuing companies witness a significantly higher than average CAR while three TABLE 6 Effect of ADR Issuance on Stock Returns 2-trading-day cumulative 2-day CAR t-ratio of the abnormal returns (CAR) prior to ADR difference of over the period issuance CAR prior to issuance over Mean Std. Dev. n mean CAR HDFC ** ICICI ICICI Bank ** Infosys ** MTNL ** Dr. Reddy s Lab ** Silverline Tech ** Satyam Comp Serv * VSNL Wipro ** * Significant at 5% level ** Significant at 1% level 41

14 I C R A B U L L E T I N APRIL SEPT..23 It appears that ADR issuance is indeed associated with a statistically significant rise in the abnormal return of the stock beginning about a experience significantly negative average CAR, and one is insignificant. Thus it does not appear that issuance of ADRs unambiguously boosts the market returns of the issuing company. Sometimes it does, and sometimes it does the opposite. 8 To get an overall impression of the effect of ADR issuance on stock returns, as well as to study the evolution of the cumulative abnormal returns around the issuance (from about a month prior to a month after the issuance date), we plot the average CAR of these ten ADR-issuing stocks in Figure 4. On the whole, it appears that ADR issuance is indeed associated with a statistically significant rise in the abnormal return of the stock beginning about a week before the issuance date. However, a large part of the increase appears to be shortlived with the cumulative abnormal return dropping to prior levels within a week of the ADR issue. 12% 1% 8% FIGURE 4 Average CAR around ADR Issuance week before the issuance date. However, a large part of the increase Average CAR 6% 4% 2% % appears to be shortlived with the cumulative abnormal return dropping to prior levels within a week of the ADR issue. 42-2% EventDate F. Effect of ADR on a stock s relationship with US market Prior research has suggested that the existence of an ADR and the resulting access of foreign investors to a company s stock often weaken its relationship with the domestic market. Sometimes there is a strengthening of its relation with the US market. In this sub-section we 8 The success of the ADR issue measured in terms of its opening premium does not explain this variation either (in fact it has a slightly negative correlation with the abnormal return). A more appropriate factor would perhaps be the unanticipated success. However, given the small number of ADR issues in our sample, no conclusive inference about the causes of this variation can be drawn, and any formal statistical attempt would be futile here.

15 look at whether that has been the case for Indian stocks with exchangetraded ADRs. Table 7 shows the beta (i.e. sensitivity) of the ten stocks under consideration with respect to the Indian market (the BSE National Index) and the US market (the SP 5 Index) before and after the issue of ADRs. The R 2 of the regressions of weekly returns of the stock on the weekly returns on these two indices are also provided for both these sub-periods. We use weekly returns here to avoid certain potential econometric problems 9 in daily data. The final column checks if there is actually a statistical break in the relationship of the stock and the two indices with the issue of the ADR. I C R A B U L L E T I N APRIL SEPT. 23 TABLE 7 Effect of ADR Issuance on Relationship of Companies with Domestic and US Market Pre-ADR Post-ADR Chow test β India β USA R 2 β India β USA R 2 p-value HDFC.49** ** ICICI 1.44** ** ICICI Bank.66* ** Infosys 1.5** **.36*.52. MTNL.94** ** -.51* Dr. Reddy s Lab.51** ** Silverline Tech 1.86** ** Satyam Comp Serv 1.84** ** VSNL 1.19** ** Wipro 2.16** **.44* * Significant at 5% level ** Significant at 1% level The result shows that only in two cases the infotech companies Infosys and Wipro have the issue of ADRs resulted in an increased beta of the stock with the US market. Even out of these two companies, only in the case of Infosys has the relationship witnessed a structural change with the issue of the ADR. Notably, for both these stocks the betas with the Indian market have also slightly increased in the post-adr period, contrary to what the literature would predict. Interestingly MTNL s US beta did experience a significant change after the issue of the ADR, but in the opposite direction its US beta became negative and significant! Its local beta also increased. However, there is no evidence of a structural change in this case from the Chow test (a statistical method of verifying whether the beta remained equal before 9 Stock returns data are frequently heteroscedastic, i.e., exhibit varying volatility of the error term, requiring GARCH-type modeling rather than simple regressions. Such problems are usually more marked at higher frequency (daily) data than weekly data. 43

16 I C R A B U L L E T I N 44 APRIL SEPT..23 On the whole it is difficultto generalise the impact of ADRs on the qualitative relationship of the stock with the US market, but the generally held belief that ADRs lead to lower co-movement of the underlying stock with the domestic market is far from being strongly applicable for Indian companies with exchange-traded ADRs. and after the ADR issue) so the result is not exactly unambiguous. Only four out of the ten stocks witness a weakening of their estimated relationship with the Indian market while the others appear to experience the opposite. Even these four cases are not backed by the Chow test and are statistically insignificant. On the whole then, these results indicate that it is difficult to generalise the impact of ADRs on the qualitative relationship of the stock with the US market, but the generally held belief that ADRs lead to lower co-movement of the underlying stock with the domestic market is far from being strongly applicable for Indian companies with exchange-traded ADRs. In only one of the ten cases Infosys has ADR issue unambiguously coincided with a rise in the US beta. 4. Conclusions In this paper, we examined various aspects of exchange-traded ADRs from India. Considering the ten ADRs of Indian origin that currently trade on the American stock exchanges and also have the underlying stocks trading on Indian bourses, we studied the extent to which the usual predictions about ADR returns hold for this important type of cross-border securities. ADR returns appear to have unanticipated movers. The return on the underlying stock, the US-India exchange rate, the BSE National Index movements as well as the movement on two important US indices the SP 5 and NASDAQ together account for less than half of the total volatility of ADR returns in most cases. The ADRs enjoy considerable premium over their underlying stocks, indicating effective market segmentation between the US and Indian markets. Infosys enjoys particularly high premiums but much of its premium is determined by the swings in the NASDAQ index. US market indices also affect the premium on other ADRs from India, though to a smaller extent. The ADR returns also have low correlation with the underlying stock returns and the exchange rate, but there is no evidence of any systematic bias in the ADR returns their excess return over their underlying stock is essentially zero in all cases. This is indicative of additional randomness in ADR returns originating from essentially US markets, with little connection to the Indian stock returns. As with returns, volumes appear to have little cross-border connection as well. A priori, one could expect event-driven or uncertainty-driven trading to induce high correlation in trading volumes (events, news or greater uncertainty that spur heavy trading in India may be expected to have similar consequences on ADR trading as well). However, only a small part of the variation in traded volume for ADR is explained by the variation in the traded volume for the underlying stock. ADR issue appears to boost underlying stock prices temporarily. There is an increase in abnormal returns of the stocks (stock return

17 less the BSE National Index return) just prior to the ADR listing, but this increase is mostly ephemeral. There is, however, considerable variation in this effect. Finally, ADR issues do not appear to have made the Indian stocks less connected to the Indian market. The impact of the US market also does not increase in most cases. Thus, the inclusion of foreign investors in a stock s pool of shareholders does not appear to have made a considerable impact on the pattern of returns for the Indian companies with exchange traded ADRs. We can only speculate about the reasons for our findings. Randomness is an inherent and perhaps welcome feature of all asset prices. It is, therefore, not so surprising that ADR prices exhibit so little predictability. However, ADRs being derivative instruments, too much deviation from the fundamental prices does open up arbitrage opportunities. Clearly then, this difference is reflective of market segmentation (in the sense that the no-arbitrage condition does not hold) between India and the USA. Our finding that ADR issues have not substantially altered the sensitivity of the stocks in question to the domestic and US markets, once again underscores the disconnect between the ADR market and the domestic stock market stemming from the regulatory causes of segmentation discussed before. The fact that the randomness does not have a positive or negative bias on average, however, is reassuring, indicating no systematic mis-pricing of the ADRs. Our results indicate that US market factors, not completely captured in major US indices, affect ADR price movements. Sectoral performances and reputations may have a role in explaining the high premiums for Infosys and the two financial companies in our sample. Behavioural reasons may well explain a large part the high premiums for Infosys at the peak of the dot-com boom. As for the effect of ADR issue on prices of underlying stocks, our results indicate some degree of irrational exuberance concerning ADR issues, which may well decline with time and as ADR issues become more common. We hope further analysis of these findings and identification of their driving factors will prove to be interesting goals for future research. References Foerster, S.R. and G.A. Karolyi, The long-run performance of global equity offerings, Working Paper, Ohio State University, Columbus, OH. Hansda, S.K. and P. Ray, 23. Stock Market Integration and Dually Listed Stocks: Indian ADRs and Domestic Stock Prices, Economic and Political Weekly, February 22, 23. Jayaraman, N., Shastri, K., Tandon, K., The impact of international crosslistings on risk and return: The evidence from American depositary receipts, Journal of Banking and, vol. 17, pp Jitendranathan, T., T.R. Nirmalanandan and K. Tandon, 2. Barriers to international investing and market segmentation: Evidence from Indian GDR market, Pacific-Basin Journal, vol. 8, pp Karolyi, G.A., Why Do Companies List their Shares Abroad? A Survey of the Evidence and its Managerial Implications, New York University Salomon Bros. Center Monograph Series, Volume 7, Number 1. I C R A B U L L E T I N APRIL SEPT. 23 The ADR returns have low correlation with the underlying stock returns and the exchange rate, but there is no evidence of any systematic bias in the ADR returns their excess return over their underlying stock is essentially zero in all cases. 45

18 I C R A B U L L E T I N APRIL SEPT..23 Miller, D.P., The market reaction to international cross-listings: Evidence from depositary receipts, Journal of Financial Economics, vol. 51,13,123. Pinegar, J.M. and R. Ravichandran, 22. Global and local information asymmetries, illiquidity and SEC Rule 144A/Regulation S: The case of Indian GDRs, Journal of Banking and, vol. 26, pp Appendix: The Data This study looks at the ten Indian origin ADRs that trade on US markets with their underlying shares trading on Indian bourses (those listed in Table 1 except Rediff.com and Satyam Infoway). The data comprises daily closing price observations on the ADRs and the underlying stocks, the exchange rate between the US dollar and the Indian Rupee, the value of the Bombay Stock Exchange National Index, the SP 5 Index and the NASDAQ Index. Our data ranges from March 16, 1999 to January 17, 23 for all stocks, except Infosys for which our data begins on January 1, 1998, to cover a substantial pre-adr period. The daily volume of trade for the ADRs and their underlying stocks are also recorded. All data used in this study come from DATASTREAM. Continuously compounded daily returns are computed from the closing prices as the difference in the logarithm of two consecutive daily prices (or exchange rates). Continuously compounded weekly returns are computed using closing prices. Note that for the same date in the two markets India and the US the Indian market actually leads the US market for time zone differences. Thus Indian markets are already closed for the day when the US markets open. Hence, in studying the effects of events in Indian markets on US markets using regressions, there is no need to consider lags; the necessary lags are already built in the data. 46