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The linkage between the U.S. “fear index” and ADR premiums under non-frictionless stock markets

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Abstract

This paper examines the effects of the U.S. investor sentiment on American depository receipts (ADR) premiums by using daily prices of Latin American ADRs from 1995 to 2009. The volatility index (VIX) is used as a proxy for investor expectations about the stock market. High levels in the VIX indicate that investors are fearful about future performance of the U.S. stock market. We estimate a GARCH-M in the framework of an ADR pricing model. We control for liquidity, transaction costs, and domestic and U.S. stock exchange returns. We find that deviations from the law of one price in ADRs can be partially explained by the lag of the smoothed volatility index. There is a structural break in the sample period before and after the enactment of the Sarbanes-Oxley Act. This paper has important implications for portfolio diversification on emerging economies as investment managers can improve hedging strategies by incorporating known values of the volatility index.

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Notes

  1. For instance, the number of type 2 and type 3 ADR programs from Latin America rose from 22 in 1994 to 81 by the end of 2010. Type 2 and type 3 ADR programs are traded on U.S. Exchanges and they are the most restrictive types of programs. Additionally, they tend to be the largest firms in their home country. Type 1, over-the-counter (OTC), and type 4, Rule 144-A ADRs, are excluded due to data constraints.

  2. The VIX is quoted in percentage points and translates, roughly, to the expected movement in the S&P 500 index over the next 30-day period. The index is a weighted average and is quoted in real time by the Chicago Board Options Exchange.

  3. ADR ratio refers to the number of underlying shares that one ADR can be converted to. When an ADR program is available, investors holding underlying shares can convert them into an ADR by paying the applicable fees. Investors might also choose to convert ADR into firms’ underlying stock.

  4. The underlying stock, the domestic and U.S. indices, and the foreign exchange rate are important pricing factors according to Aquino and Poshakwale (2006). Kim et al. (2000) only consider exchange rate, the domestic market conditions, and the U.S. market conditions.

  5. Following the recommendation of an anonymous referee, we note that the sampling procedure may overstate the effect of surviving ADRs. We acknowledge that the results must be interpreted with care. However, we believe the main conclusion is unlikely to change given the robustness of our findings as shown in Tables 3, 4 and 5.

  6. SOX was signed into law in July 2002 following a number of high-profile scandals and imposes more stringent disclosure requirements in order to prevent accounting misconduct. Chira (2011) finds that ADR returns have a structural break pre- and post-SOX.

  7. This trend can be observed on Fig. 2. Figure 2 employs the CRSP value-weighted index representing the total market. The cutoff point is the month where the stock market reached bottom in 2002.

  8. Implied volatility was initially proposed as a measure of expected volatility by Latane and Rendleman (1976) and Chiras and Manaster (1978).

  9. Several authors agreed that the mid 1990’s is a period where emerging countries started to become more integrated to world capital markets (Henry 2000; Bekaert and Harvey 2000; Bekaert et al. 2005; Esqueda et al. 2012).

  10. The S-VIX is expressed in percentage and follows a smoothing procedure with a 1-month trailing period, where the most recent value has half of the weight.

  11. When the two models are compared, the latter approach has a higher predictive power than the simple VIX index.

  12. See Esqueda and Jackson (2012) for a description of the financial crises in these four Latin American economies.

  13. Turnover has been commonly estimated as the volume of shares traded divided by the number of shares outstanding. We estimate daily turnover and is winsorized at the 2 % and 98 % levels.

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Correspondence to Omar A. Esqueda.

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We are grateful to participants of the 47th AEF Annual conference for relevant suggestions on an earlier version of the manuscript. We also thank participants of the 50th SWFA annual meeting in Houston, TX for constructive comments. We recognize Dr. Diego Escobari, Dr. Emilios Galariotis, and Dr. David Johnk for valuable inputs. We are grateful to an anonymous referee for important suggestions. All remaining errors are our own.

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Esqueda, O.A., Luo, Y. & Jackson, D.O. The linkage between the U.S. “fear index” and ADR premiums under non-frictionless stock markets. J Econ Finan 39, 541–556 (2015). https://doi.org/10.1007/s12197-013-9265-z

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