Price And Volatility Transmission Between ADRs And Their Underlying Stocks

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Price And Volatility Transmission Between ADRs And Their Underlying Stocks: Evidence From The Korean Case

Sang Hoon Kang

Pusan National University

Seong-Min Yoon

Pusan National University; IPAG Business School

April 30, 2011

Korea and the World Economy, Vol. 12, No. 1 (April 2011) 1-18.


This study investigates the spillover effect of price returns and volatility between ADRs and their underlying Korean stocks, employing a Granger causality test and a bivariate GARCH model. First, the empirical results of Granger causality test suggest bi-directional transmission of price returns between the ADRs and their underlying stocks. Second, the empirical results from the estimations of bivariate GARCH model indicate that volatility spillover effect exists between the ADRs and underlying stocks. In addition, due to the small and illiquid Korean ADR market, it is evidenced that direction of volatility spillover effect from the home market to the ADR market, but the evidence is very weak.

Price And Volatility Transmission Between ADRs And Their Underlying Stocks: Evidence From The Korean Case – Introduction

For theoretical and empirical reasons, the returns and volatility transmission amongst equity markets have drawn the attention of numerous academics and practitioners because they both play crucial roles in portfolio and risk management. Due to the increasing integration of international equity markets and recent global financial crisis, the information flows is more speedily spread around international equity markets and thus equity markets are integrated and interdependent each other. Thus, the market linkage amongst equity markets is an important ingredient for the portfolio diversification, arbitrate trading and risk management for both international as well as domestic investors.

Cross-listings of shares and issuance of American Depositary Receipts (ADRs) by foreign companies in the US have played a significant role in the market liquidity, international diversification, arbitrage opportunities and capital market integration (Gande, 1997; Karolyi, 2004). In particular, ADRs provide a unique opportunity to investigate price interaction channels between the US and non-US equity markets. The studies of ADRs have become an important ingredient of analyzing market integration among international equity markets. Numerous studies have already documented the price transmission with consistent results indicating that ADRs price returns have a bi-directional relationship with the underlying stock price returns (Choi and Kim, 2000; Kim, Szakmary, and Mathur, 2000; Ely and Salehizadeh, 2001; Faff, Hodgson, and Saudagaran, 2002; Rabinovitch, Silva and Susmel, 2003; Lim, 2008).

Another ongoing debate is to examine the volatility spillover between the ADRs and the underlying stocks. The evidence of volatility spillover indicates strong cross-market dependence in the volatility process. There are three different agreements in existing literature. The first group argues that the underlying markets affect the returns and volatility in the ADR markets. Choi and Kim (2000) found that price returns of underlying stocks are important determinants of the ADRs. Mak and Ngai (2005) reported a significant volatility spillover between Hong Kong stocks and their ADRs. Their result indicated that the home market influenced the pricing of ADRs. Kutan and Zhou (2006) also showed that conditional volatility of the Chinese ADRs is influenced by the innovations in the underlying stock markets.

The second group of these studies reported a uni-directional relationship from the ADRs to their underlying stocks. Alaganar and Bhar (2002) examined the information flow between dully listed stocks traded in Australia and US. They suggested that the ADR market dominates the Australian market. Jaiswal-Dale and Jithendranathan (2009) explored the effect of information shocks using cross-listing stocks in US and German markets. They found that returns and volatilities of domestic markets are affected by US shocks.

The final group supports bi-directional relationship between the ADRs and their underlying share markets. Park and Kim (2001), and Kim (2005) examined information flows between the ADRs and their Korean underlying stocks, taking into account the Asian currency crisis. They found that strong bi-directional spillover effect exists in both price returns and volatility after the Asian currency crisis, implying that the crisis has intensified the information transmission from the non-US market to the US market. Iwatsubo and Inagaki (2007) reported significant a bi-directional spillover effect in the return and return volatility of some Asian markets. Poshakwale and Aquino (2008) investigated volatility dynamics and information flow between 70 ADRs and their corresponding stocks. They reported a bidirectional volatility transmission and information flow between both markets.

The main objective of this study is to investigate the magnitude and direction of price returns and volatility spillovers between ADRs and their underlying stocks. For this purpose, we focus on the ADR market for the emerging ADR market, i.e., Korean ADRs. Although the ADRs from emerging markets bring diversification benefits to US investors and can serve as a proxy for the home markets, most emerging ADRs is less activated than their underlying stocks so that information flows of underlying stocks might be transmitted into ADR prices. In this context, we give rise to question on whether emerging underlying stocks in the home market affect ADRs in the US market or not. The use of ADRs provides a unique vehicle to measure the information flows form the non-US market to the US market.

Price And Volatility Transmission

Price And Volatility Transmission

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