ADR or American Depositary Receipt is a US security that represents an ownership interest in another security of a non-US company. It enables investors to acquire foreign securities without concerning for cross-border transactions, illiquidity, and dividend conversion while maintaining similar benefits of investing internationally.
As ADR represent an ownership interest in its underlying foreign security, the ADR and Underlying Stock should be the same at all times after adjusting exchange rates
This is known as Law of one price (LOP).
If this is not true, there will be options of ADR arbitrage by which the prices shall come to equilibrium.
ADR arbitrage - an investor would be able to buy it cheaply, convert it back to the underlying stock, and sell it for a higher price in the foreign market.
Thus an investor will arbitrage these differences away and make a riskless profit.
However, these two prices diverge and the ADR might trade at premium or a discount to its underlying stock. My aim is to understand the differences of prices between such and try to understand the reason and see if there is a correlation.
For my study, I shall use the following notations.
ADR - Security in US. The values refer to NYSE.
IDR - Security in India. The value is obtained from NSE or BSE.
For both ADR and IDR, the historical values are obtained from http://finance.yahoo.com and the exchange rates between USD and INR are obtained from http://www.exchange-rates.org/history/INR/USD/T
For the study purpose, I have taken the values from 1st March 2010 till 11th August 2010.
Reference - I have studied the following materials for my analysis and understanding
www.utiicm.com/Cmc/PDFs/2002/hansda-ray%5E15.pdf
www.icra.in/files/pdf/MoneyAndFinance/sudipamajumdar-feb07.pdf
www.nipfp.org.in/working_paper/wp_2010_71.pdf
http://people.hbs.edu/mdesai/IFM05/AmaryOttoni.pdf
http://www.igidr.ac.in/~susant/DERBOOK/outline.html
http://adr.com
Types of ADRs
Unsponsored shares: These are ADR's that trade in the OTC market. They are issued according to market demand and have no regulatory reporting requirements. These ADR's are no longer traded.
Sponsored ADR's: All ADR's (Level 1, 2, 3, Rule 144a) are sponsored ADR's. The issuer company will sign an exclusive agreement with a depository bank that will spell out the legal relationship between the depository bank, the custodian and the issuer company (please see section below 'Parties Involved' to understand mechanics of sponsored ADR's)
Level1 ADR's: Over the counter through the OTC bulletin or the Pink Sheet listed on a US exchange.
Level 2 ADR's: These are exchange traded ADR's that are listed on one of the U.S National Exchanges such as NYSE, NASDAQ or Amex.
Level 3 ADR's: These are ADR's that allow the issuer to raise new capital through a public offering on one of the US exchanges.
Rule 144a ADR's: Privately placed with Qualified Institutional Buyers under the rule 144A market.
ADRs are issued by a U.S. bank that functions as a depositary, having ADR being backed by a specific number of shares in the non-U.S. company. ADRs can be traded on any of the US stock exchange (NYSE, NASDAQ, or AMEX) and over-the-counter. In the case of Rule 144A, they are privately placed and traded.
The following is a table of Indian ADRs trading on US Exchanges (NYSE, NASDAQ). Source: http://www.adrbny.com
ADR
SYMBOL
EXCH
RATIO - ADR:ORD
INDUSTRY
DR. REDDY'S LABORATORIES LTD.
RDY
NYSE
1:01
Pharmaceutical
HDFC BANK LTD.
HDB
NYSE
1:03
Banks
ICICI BANK LTD.
IBN
NYSE
1:02
Banks
INFOSYS TECHNOLOGIES LIMITED
INFY
NASDAQ
1:01
Technology Services
MAHANAGAR TELEPHONE NIGAM LIMITED
MTE
NYSE
1:02
Fixed Line Comm.
REDIFF.COM INDIA LTD
REDF
NASDAQ
2:01
Technology Services
SATYAM COMPUTER SERVICES LIMITED
SAY
NYSE
1:02
Technology Services
SIFY LTD.
SIFY
NASDAQ
1:01
Technology Services
TATA MOTORS LTD.
TTM
NYSE
1:01
Auto Manufacturers
VIDESH SANCHAR NIGAM LIMITED
VSL
NYSE
1:02
Fixed Line Comm.
WIPRO LTD.
WIT
NYSE
1:01
Technology Services
PATNI COMPUTER SYSTEMS LIMITED
PTI
NYSE
1:02
Software & Computer Svc.
Advantages of using ADRs from the view of the Investor
Simplify the trading. It can be traded in USD and settled in USD like any other US Security.
Reduce the risk and cost of transaction
Eliminates international barriers and helps in diversification of portfolio
Provides International Exposure for emerging markets
Provides faster USD Dividend Payouts.
Advantage from the issuer point of view
Access to capital and international exposure
Branding
Increase local price: As a result of global demand, local prices may increase
M&A and corporate action activity
Employee Compensation: Compensate the US talents by giving options
Disadvantages of using ADRs:
Local Shares may not be "fully fungible" in several countries. Till 2001, for IDRs there were no two-way fungibility.
Capital Control regulations for Home Country
Few Reasons on why the IDR and ADRs are different in valuations.
Time Difference for trading hours
Fees and transaction costs (Broker, Stock Exchange and Conversion Rate of USD to INR)
Local government regulations, different rights and protections are accompanied by the certificate.
Are ADRs and IDRs the same assets?
ADRs and IDRs are different certificates and may not be "fully fungible" in several countries.
In 2001, RBI allowed two-way fungibility between ADRs and IDRs with restrictions, however, to what shares could be converted to ADRs.
Under this regulation, only IDRs that were created through conversion of ADRs can be reconverted. The high demand for Indian shares in the U.S. during the past few years and the relatively low volume of ADRs available for investors resulted in most Indian ADRs trading at a premium over their local shares.
Sponsored vs. unsponsored ADR program, different levels of ADRs
Issuers can usually choose from different types of ADRs, ranging from unsponsored to Rule 144A.
Each of the sets has specific benefits and rights to the investors and has its particular legal & regulatory requirement.
Correlation to stock index between ADRs and local shares
Another disparity between ADR prices and IDRs are the co-movements between the stocks and the markets they are traded rather than where the company is established.
During the analysis I had to keep in mind the following thing
Non-synchronous data
Real time arbitrage between IDRs and their ADRs is not possible. There is 10+ hours difference between U.S. and Indian time zones. The regular trading session in the BSE in India begins at IST 9:00AM and ends at IST 03:30PM, while the trading session in the NYSE/NASDAQ in the U.S. starts at IST 08:00PM and ends at IST 02:30AM of the next day.
Indian market regulation Capital Control, Fungibility
It is impractical to exploit the apparent arbitrage opportunities between IDRs and ADRs. An investor can not simply take the following steps
Take loan in INR
Buy IDRs from Indian Market
Sell in USA
Convert USD to INR
Repay the loan
Possible Reasons why ADRs could be overpriced or Discounted
Excess demand for Emerging market - for Indian high growth companies that list on the US market.
Limited supply of ADR's. Typically, ADR's represent only 3% - 6% of the market capitalization of a stock.
The Indian stock market is characterized by lower trading volumes and liquidity levels compared to the US markets.
ADR's also provide a value added layer - transparency, liquidity and greater coverage than the existing Indian stock.
Finally, until very recently there have been currency controls in India. While the Indian Rupee is not freely convertible yet, there is more convertibility available today.
Let me try quantify the factors in mathematical terms
Price/value
a. ADR: Price of ADR or PADR
b. Stock: Price of home country stock: PIDR
c. Market Index (NYSE, Nasdaq, OTC, Sensex, BSE): Msensex, MDJ
2. Volume
a. ADR: Volume of ADR traded daily or VADR
b. Stock: Volume of Stock traded daily or VIDR
c. Market: Total market volume -Vsensex, VDJ
Let me see if ADR/IDR could be modeled as a regression function
PADR/PIDR = F (PADR, PIDR, Msensex, MDJ, VADR, VIDR, Vsensex, VDJ)
Here are the plots for the Sensex, DJ Industrial Average and the Premiums for Selected 4 IDRs
Taking a snapshot for one month for the Odd Days the graph looks like
The following conclusions can be made from the graphs above
Tata Motors and Infosys have a higher premium indicating the investors' confidence in US Market
ICICI premium is almost between -1% to +1%
Wipro has a discount in ADR and showing possible negative sentiments across the investors
Calculating the Minimal Statistics shows the following
Regression Analysis Result for Wipro and Tata Motors for the data available (Output from SPSS SW)
Wipro
Tata Motors
High value of R Square in the analysis implies that a Strong correlation exist
High value of R Square in the analysis implies that a Strong correlation exist
Hence For Wipro
PADR = 73.486 + 0.835*PIDR - 0.011*Msensex + 0.015*Mdjones
High value of R Square in the analysis implies that a Strong correlation exist
It does not however tell there is any significant association with Volume of Shares Traded in India or in USA. Neither does it tell there is any association between Sensex or DowJones value.
Hence For Tata Motors
PADR = -289.048 + 0.686*PIDR + 0.014*Msensex + 0.032*Mdjones
High value of R Square in the analysis implies that a Strong correlation exist
It does not however tell there is any significant association with Volume of Shares Traded in India or in USA. Neither does it tell there is any association between Sensex or DowJones value.
For Tata Motors, the association of Sensex value to the ADR price is of low confidence.
Exhibits
The following historical values have been considered in my analysis. The details are attached at the end of the document.
Complete Excel Sheet -
