Analysis and Trend in American Depository Receipts (ADR) Premium for Indian Companies

Seminar Paper

By

Ajit Kumar
PGDM-IB Roll 23

Under the guidance of

Prof. C.P Joshi HOD & Course Coordinator SIMSR, Mumbai

Prof. B. Bhatia Professor SIMSR, Mumbai

K J Somaiya Institute of Management Studies & Research

08/12/2011

Table of Contents
Introduction ...................................................................................................................................... 3 Literature Review .............................................................................................................................. 3 ADR Definition ............................................................................................................................... 3 Types of ADR s ............................................................................................................................... 4 Benefits to U.S Investors ................................................................................................................ 5 Benefits to Issuers of ADR s............................................................................................................ 5 ADR Structure ................................................................................................................................ 6 Parties and Transactions ................................................................................................................ 6 Investing in an ADR ........................................................................................................................ 7 Trading Characteristics of Dually Listed Companies ............................................................................ 8 Scatter of ADR Equivalent Prices and NSE Closing Prices .............................................................. 10 ADR Premium Levels over the Underlying ........................................................................................ 11 ADR Premium and Reasons for Premium ..................................................................................... 12 Summary and Findings..................................................................................................................... 13 References and Bibliography............................................................................................................ 14

Introduction
In ideal markets, the law of one price (LOP) holds. The empirical literature has identified LOP violations in many situations. As an example, commodities markets exhibit substantial LOP violations. Transportation costs, nontariff barriers, non-traded components as labour costs and taxes and finally heterogeneity of commodities leads to LOP violations. Financial securities can, in principle, achieve extremely efficient pricing given the absence of these physical frictions. American Depository Receipts (ADRs) and domestic shares are exactly the same asset and there is no non-traded component or transportation cost. Hence, one would expect that the price would be the same. In some situations, ADRs are indeed priced extremely efficiently; however, capital controls and other trading frictions can interfere with arbitrage, and result in a lack of efficient pricing. This seminar paper intends to examine the inter-linkages between Indian and Japanese ADR premiums and macroeconomic parameters. Most of the ADRs have been listed in the US for some time continues to trade at premiums. Also the fact that these premiums are not a onetime aberration but have been in existence for a long time (in case of Infosys, the premium of >30% can be traced back to its listing in the US in March 1999).

India is a large emerging market with a highly liquid domestic market. There are two key impediments to ADR arbitrage for Indian underlying. First, the structure of capital controls impedes arbitrage, but only when the ADR premium is positive. Second, the time difference between New York and Bombay implies that there is no time of day at which both markets are open. These problems have generated persistent LOP violations in the form of large and positive ADR premiums. The size and persistence of this pricing error is much unlike that seen with other countries.

Literature Review
ADR Definition
American Depository Receipts are financial instruments that allow investors in the U.S to purchase shares of non-U.S companies. In order to align the trading price of the DR to customary price levels in the trading market, each ADR represents a number of underlying
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shares on deposit with a custodian in the issuers home market. So for example, 1:10 means that 1 depository receipt or 1 certificate = 10 ADSs (American Depository Shares in the local company). ADRs are quoted and traded in $US and are subject to the rules and regulations of the stock exchange or trading system on which they trade - for example the ASE, NYSE, Nasdaq or in the OTC market. Other than the exchange ratio, an ADR is characterized by price, volume, shares outstanding and exchange.

Types of ADR s
There are several types of ADRs which we describe below: y Unsponsored shares: These are ADRs that trade in the OTC market. They are issued according to market demand and have no regulatory reporting requirements. These ADRs are no longer traded. y Sponsored ADRs: All ADRs (Level 1, 2, 3, Rule 144a) are sponsored ADRs. 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 ADRs) y Level 1 ADRs: Over the counter through the OTC bulletin board or the Pink Sheetlisted on a US exchange. Level 1 ADRs are suitable for issuer companies that wish to diversify their US investor base without complying with the regulations of a U.S exchange. They have minimal reporting SEC requirements and are not required to issue annual or quarterly reports. y Level 2 ADRs: These are exchange traded ADRs that are listed on one of the U.S National Exchanges such as NYSE, NASDAQ or Amex. The benefit of issuing a Level 2 ADR is more visibility in the US market and therefore more liquidity in trading. This is due to wider analyst coverage of Level 2 ADRs. The issuer must comply with the regulations of the SEC and the appropriate exchange. y Level 3 ADRs: These are ADRs that allow the issuer to raise new capital through a public offering on one of the US exchanges. This type of ADR allows the issuer the most visibility in the US but also requires the strictest adherence to SEC regulations, similar to the ones that US companies face.

Rule 144a ADRs: Privately placed with Qualified Institutional Buyers under the rule 144A market. Will be quoted on PORTAL in the U.S. Not accessible to the general public. The benefits for this type of ACR is that it allows the issuer company to raise capital for the QIBs in the US with out adhering to the strict regulations required by Level 3 ADRs.

Benefits to U.S Investors

y Access and Diversification: ADRs give investors in the U.S access to investments outside their own country. Indian regulations for example do not permit non-Indian nationals to invest directly on the Sensex exchange. So the only way for US investors to invest in Indian securities is through emerging markets funds or ADRs. y Liquidity: The liquidity of ADRs makes them attractive instruments for U.S investors who wish to invest in companies outside their home market. y Safety and Transparency: U.S investors have greater access to company research, and price and trading information. Additionally trading, clearing and settling of trades takes place in accordance to U.S market regulations. Dividend payments are paid in $US and corporate action notifications are made in English. y y Comparability: U.S investors can easily compare U.S securities with ADRs. Lower tax rates on dividends: Investors may benefit from lower tax obligations on dividends made by issuers of exchange listed ADRs in cases where there is a treaty between U.S and issuers local market.

Benefits to Issuers of ADR s

y Access to capital and international exposure: Indian companies can raise capital outside of India and broaden their shareholder base. In doing so they can increase liquidity of their stock and therefore its attractiveness. y y y Branding: Indian companies can raise their profile internationally. Increase local price: As a result of global demand, local prices may increase. M&A and corporate action activity: Increase merger and acquisition activity by allowing the issuer to use ADRs as acquisition currency. Additionally, ADRs facilitate the execution of corporate actions such as dividend payments and solicitation of votes.

Employee Compensation: Issuer companies may compensate U.S employees with stock option plans which will allow foreign companies to hire U.S talent.

ADR Structure
The structure of an ADR includes a ratio, which correlates the amount of underlying shares to the receipt.

Parties and Transactions

Issuer Company y Selects lawyers, investment bankers and accountants and seek approval from board of directors as needed. y y Determines ADR program type: Level 1, Level 2, and Level 3. Develops an investor relations plan to coordinate investor targeting and provide road show and presentation advice. y Selects and signs exclusive agreement with a depositary bank in U.S.

Depositary Bank Appoints custodian bank in India. Advises on DR structure and registration requirements. Prepares and issues ADRs.

Custodian Will receive the underlying shares from the Issuer Company and hold shares in custody for the account of depositary in the home market. The Custodian will also breakdown corporate action information for the depositary Investment Bankers Lead underwriting process, establish syndicate of participating banks, advise on capital structure, conduct due diligence, draft prospectus, obtain CUSIP number, coordinate roadshow, organize book building and price and launch securities. Lawyers Negotiate deposit agreements; prepare listing agreements to list on appropriate exchanges. Accountants Prepare financial statements in accordance with U.S GAAP. DTC (Depositary Trust and Clearing Corporation) Works closely with depositories to facilitate the issuance and cancellation of DRs Provides safekeeping and settlement to ensure the safety and settlement of DR transactions.

Investing in an ADR
Steps: 1. US investor contacts US broker and requests purchase of ADR. If no existing ADR s are available, new issuance begins. 2. US broker contacts local broker in Bombay 3. Local broker purchases local shares on local exchange 4. Ordinary shares are deposited with local custodian 5. Local Custodian instructs depositary bank in the US to issue ADR s that represent the ordinary shares received. 6. The depositary bank issues ADRs and delivers them in physical form through the DTC. 7. The broker delivers the ADRs to the investor or credits the investors accounts.

Figure 2: Steps for investing ADR

Trading Characteristics of Dually Listed Companies

The focus of this study is to observe the price trend of each dually listed stockLets therefore, considered the time trend of five years for each company after their foreign listing. Only those firms that were listed before December 2001 have been considered for this analysis. The ADR prices in US dollar terms were converted into Indian Rupees by adjusting for the exchange rate for each particular day of trade. The ADR ratio of each stock was considered to estimate the equivalent, comparable ADR price. The equivalent prices were then compared with the price of the underlying stock on the National Stock Exchange (NSE). The closing price of ADR as well as the closing price on the NSE for each day was taken for all calculations. In order to find out the relationship between the prices of the dually listed stocks, the ADR equivalent prices of each stock to the closing prices of the same underlying securities on the National Stock Exchange were compared. As a first step, the scatter of the ADR equivalent prices and the NSE closing prices of the same stocks were plotted for each of the eight companies that have been taken in this sample (see Graph 1). The scatter clearly showed a strong positive correlation between the prices of the dually listed Indian stocks. In order to find out the magnitude of the relationship, the correlation coefficient between the ADR price and the NSE price was calculated for each stock. The correlation coefficient was found to be very high, around 0.9, for the ADR price and the corresponding domestic share price. The sectoral break-up revealed that the synchronisation between the foreign and the
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domestic market was strongest for the finance companies that were considered for analysis, namely ICICI Bank and HDFC Bank. All the other companies, with the exception of Infosys and MTNL, showed correlation coefficients of more than 0.96.

Scatter of ADR Equivalent Prices and NSE Closing Prices

Source: Money and Finance

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A closer look at the scatter diagram showed that the majority of the points on the scatter are to the right of the 45 degree line. Each scatter point to the right of the 45 degree line indicates that the equivalent ADR price for that trading day was higher than the prevailing price of the same stock on the domestic NSE. This throws light on the existence of premium in the ADR markets over the domestic prices. (The price data are from 1st January 2001 for those companies that were listed on American stock exchange before that date.)

The summary of the correlation is presented in the Table 2 below. The correlation coefficient was found to be very high (around 0.9), for the ADR price and the corresponding domestic share price. The sectoral break-up revealed that the synchronisation between the foreign and the domestic market was strongest for the finance companies that were considered for analysis, namely ICICI Bank and HDFC Bank. All the other companies, with the exception of Infosys and MTNL, showed correlation coefficients of more than 0.96.

ADR Premium Levels over the Underlying

The prices of the same stock in two markets are expected not to differ widely when there are arbitrage possibilities, whereby investors would simultaneously purchase and sell equivalent securities in two different markets in order to profit from discrepancies in their price relationship.

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ADR Premium and Reasons for Premium

The inter-sectoral average premia levels indicate that the Information Technology (IT) companies have enjoyed the highest premia levels (an average of 28%). Infosys has been the clear winner, reaching its peak of more than 60% premium level in 2002.24 Satyam and Wipro started with low premium levels, and enjoyed a positive trend up to 2004. After the introduction of two-way fungibility in February 2002, the premia levels of Wipro and Satyam continued to rise for another two years, with premia levels going beyond 40% in 2004, which was in contrast to the expectations.

Arbitrage opportunities help to diminish the discrepancies in prices, reducing the premium levels. However, the Indian government had restrictions on the conversion and re-conversion of ADRstill 2002, India followed the one-way ADR programmes, where ADRs once issued could be cancelled and converted into the underlying Indian shares (after a delay of 45 days from the closing date of the issue) but subsequent re-issuance of ADRs was not permitted and this posed restrictions on arbitrage opportunities. So, even when identical stocks in the domestic market and ADRs traded at different prices, the prevailing trading

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restrictions resulted in high premia in the ADR market21the higher ADR prices have been explained by higher liquidity in the US stock market and the associated costs for transactions.

Second, Indian local investors are allowed to hold only the securities that are listed on the Indian stock exchanges while US investors may hold Indian securities listed on the American stock exchanges as well as purchase other securities listed in other foreign stock markets.

Third, differences in trading hours cause a lead-lag relationship in information transmission between the ADR and the local markets. There is a distinct difference in the timings of trade in the two stock marketsin India trading starts at 10am and ends at 4pm while the trading session in US spans from IST 8pm to IST 2:30am the following day.

Summary and Findings

1. Exchange-traded ADRs of Indian shares originated in 1999, with the listing of Infosys on the US stock market. The Indian government continued with widespread reforms of the financial sector by liberalising the procedures and environment for issue of depository receipts, which has been reflected in the growing market for ADRs/GDRs.

2. The Indian ADRs have been trading at high premia over the underlying domestic stocks, with Information Technology companies at the highest premia levels. The premia levels of VSNL and Dr Reddys Labs have been negligible.

3. Two-way fungibility was introduced in India in February 2002, to allow re-conversion of ADRsa foreign investor who held ADRs could sell the underlying shares in the market and the company was then allowed to issue fresh ADRs to the extent of the shares cancelled (known as headroom). The re-conversion was aimed at minimising the divergent ADR premium levels over their domestic stocks. However, premia levels continued to soar in 2002, 2003 and for most companies even in 2004. This was because the stocks continued to trade at premia levels in the US market, indicating absence of headroomtherefore, re-conversion was not possible and arbitrage opportunities remained restricted even after introduction of two-way fungibility.
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4. The decline in premia became evident only in 2005, but this convergence in prices was not associated with the two-way fungibility facility. Firstly, the ADR premia level showed positive relation with the S&P 500 Index of the US stock exchange. Secondly, the returns on ADRs were related positively to returns on the US stock market index while the relation with the Indian stock exchange remained inconclusive. We found that premia levels have been persistently high for IT and Finance sector companies, which had strong positive relationship between ADR returns and returns on the US stock exchange. Therefore, the ADR premia moved in line with the US stock marketforeign investors who traded in ADRs were concerned with activities in the US rather than the legislative changes or the stock price movements in India.

5. There was no conclusive effect of foreign listing on domestic share prices of the dually listed stocks. But there was a definite increase in trading volumes in the domestic market during the 100 trading days following their foreign listing, confirming that foreign listing helped to increase liquidity. Moreover, for the companies where average daily trading volume on the National Stock Exchange was found to be significantly higher after ADR listing, there were further gains in trading volumes in the ADR market during the 100 trading days following the foreign listing.

References and Bibliography

1. PREMIA IN THE INDIAN ADR MARKET - An Analysis of Trends and Causes, By Shivanker Saxena, The Leonard N. Stern School of Business Glucksman Institute for Research in Securities Markets Faculty Advisor: Rangarajan K. Sundaram , April 3, 2006 2. RBI Circular on ADR/GDR/FCCB Issues, A.P. (DIR Series) Circular No.52, November 23, 2002 3. Understanding the ADR premium under market segmentation, By Matthieu Stigler, Ajay Shah and Ila Patnaik, July 29, 2010 4. http://ajayshahblog.blogspot.com/2009/04/spike-in-adr-premium-for-tatamotors.html, last visited on 07/11/2011

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5. Arbitrage Opportunity between Indian stocks and their ADRs, International Financial Management, By Gitanjali Swamy & Lama Mansour , MBA Class of 2006 6. Lamont, O.A. and R.H. Thaler, 2003. The Law of One Price in Financial Markets, Journal of Economic Perspectives, 17 (4), pp. 191-202 7. Gagnon, L., and A. Karolyi, 2004, Multi-market Trading and Arbitrage, Ohio State University Working Paper 8. Hansda, S.K. and P. Ray, 2003. Stock Market Integration and Dually Listed Stocks: Indian ADR and Domestic Stock Prices, Economic and Political Weekly, Vol. XXXVIII, No. 8, pp. 741-754 9. RBI Website, FAQs on Overseas Direct Investment,

http://www.rbi.org.in/scripts/FAQView.aspx?Id=17

10. Indian ADR Quotes Website, http://www.equitymaster.com/stockquotes/adr.asp 11. http://www.business-standard.com/india/news/indian-adrs-draw-premium-to-domesticshare-prices/385928/

12. Retail Investors and ADR Premiums: The Case of Indian ADRs, Palani-Rajan Kadapakkam and Umesh Kumar, January 2009 13. Phylaktis, Korczak, Specialist Trading and the Price Discovery Process of NYSE Listed Non US Stocks, July 2004 14. Ashok Jogani, Kshama Fernandes, Arbitrage in India; past, present and future, October 2002 15. Blouin, Hail, Yetman, Capital Gains Taxes, Pricing Spreads and Arbitrage: Evidence from U.S cross- listed Firms, June 2005 16. Citigroup Global Transaction Services, Depositary Receipts Information Guide 17. The Bank of New York, 2005. The Depositary Receipt Markets Yearbook 2005, The Bank of New York Depository Receipts Division 18. Jefferies, State of the Indian Market 2005 19. Karolyi, G.A., 1998. Why Do Companies List Their Shares Abroad? A Survey Of The Evidence and its Managerial Implications, Financial Markets, Institutions and Instruments, Vol. 7, No. 1, pp. 1-60 20. Kim, S.H., S.H. Kim and K.A. Kim, 2002. Global Corporate Finance, Blackwell Publishers, Fifth Ed. 21. Blouin, Hail, Yetman, Capital Gains Taxes, Pricing Spreads and Arbitrage: Evidence from U.S cross- listed Firms, June 2005

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22. Rabinovitch, Silva, Susmel, Returns on ADRs and Arbitrage in Emerging Markets, April 2003 23. Grammig, Melvin, Schlog, The Role of US Trading in Pricing internationally cross listed stocks, March 2004 24. Otaviano Canuto, Pablo Santos and Paulo Sa Porto, Macroeconomics and Sovereign Risk Ratings, January 2004 25. Ashok Jogani,Kshama Fernandes, Arbitrage in India; past, present and future, October 2002.

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