Investing in ADRs requires American investors to be exposed to risks that do not exist in domestic investments. Although ADRs and their dividends are denominated in the U.S. Dollar, they are still influenced by political and economic risks of the foreign country of the underlying asset. The general consensus has been that there is a strong negative correlation between the international value of the U.S. Dollar and ADR performance. In this study, we provide an empirical analysis of the relationship between foreign exchange rates and returns of ADRs. Using daily data over the 2002-2004 period, we find no significant relationship between the returns of the ADR Indices and the international value of the U.S. Dollar. We conclude that the international value of the U.S. Dollar is not an adequate indicator of the performance of ADRs.

INTRODUCTION

American Depositary Receipts (ADRs) have been considered to be a convenient way for Americans to invest in foreign markets. However, investing in ADRs requires exposure to risks that would not be present when investing domestically. Although ADRs and their dividends are denominated in the U.S. Dollar, they are still influenced by political and economic risks of the foreign country of the underlying asset. The general consensus has been that there is a strong correlation between the international value of the U.S. Dollar and ADR performance. This relationship poses the assumption that an ADR’s positive performance is the result of the depreciating U.S. Dollar. In this study we provide an empirical analysis of the relationship between foreign exchange rates and returns of ADRs. We use daily data over the 2002-2004 period for Indices of Japanese, Swedish, British, and Euro zone ADRs. We also use daily exchange rate data for the corresponding four major currencies: the Yen, the Swedish Krona, the British Pound, and the Euro for the same period. Our empirical analysis consists of the Dickey-Fuller test, simple regressions, and the Granger Causality test. Our empirical results show that no significant relationship exists between the returns of the ADR Indices and the international value of the U.S. Dollar. Our results contradict some published empirical studies that support a strong relationship between these variables. We conclude that the international value of the U.S. Dollar is not an adequate indicator of the performance of ADRs. Our study has major implications for potential investors in ADRs.

REVIEW OF RECENT LITERATURE

Kim, Szakmary, and Mathur (2000) contend that there are three considerations in pricing of ADRs: the price of underlying shares in the local currency, the exchange rate, and the U.S. market index. With respect to the impact of the US dollar, they assert that when an ADR is purchased in U.S. Dollars it can be exchanged for the underlying foreign share and sold in the foreign currency. If the U.S. Dollar depreciates after the ADR is purchased, an arbitrage opportunity would exist because the foreign currency could then be converted back to U.S. Dollars at a more favorable exchange rate therefore producing a profit. Therefore, as the U.S. Dollar weakens, ADRs are implicitly affected due to the ability to convert ADRs to their corresponding foreign underlying shares. Kim, Szakmary, and Mathur conclude that there is an inverse relationship between the value of the U.S. Dollar and the rate of return for ADRs.

A similar inference was made by Bin, Chen, and Blenman (2002). They studied ADR performance during currency crises by analyzing the ADR returns during periods of variation in exchange rates, shifts in the exchange rate exposure of the ADRs, and the amount of risk to exchange rate variations relative to the amount of U.S. market activities that the ADR-originating firms are engaged in. Their study suggests that a crash in a foreign currency is coupled with a significant negative return for the corresponding ADRs. They conclude that when the U.S. Dollar appreciates against a particular currency, there is a negative return on the ADRs that correspond to the underlying shares of that foreign market. This implied inverse relationship between ADR performance and the value of the U.S. Dollar is in line with the result of the study by Kim, Szakmary, and Mathur.

In another empirical study, Kwon, Bae, and Chung (2003) test to see whether foreign investors consider foreign exchange risk and price risk differently than local investors. They contend that foreign investors view exchange rate risk as more of a threat to the performance of their investments than local investors. They conclude that when the value of a local currency appreciates against the U.S. Dollar, the corresponding country’s ADRs show an increase in return.

Several news publications have also reported the relationships between the price of ADRs and the value of the U.S. Dollar. A Reuters News Service’s report (January 16, 2004) titled ADR Report—European ADRs lower as stronger dollar, oil weigh states that prices of European ADRs were lowered in reaction to the rise in the value of the U.S. Dollar against the Euro. Again, this article hypothesizes an inverse relationship between the value of the U.S. Dollar and ADR prices.

Conversely, in another Reuters New Service report (October 13, 2003) titled ADR Report-ADRs get boost from Motorola, it is argued that the appreciation of the U.S. Dollar against the Euro was positive for European companies that were previously under pressure from the weakening U.S. Dollar. The depreciating U.S. Dollar had made European companies less competitive and hindered earnings. The article states that the strengthening of the U.S. Dollar can boost revenue of a foreign company that exports to the U.S. thus causing the price of the ADR to increase with the value of the U.S. Dollar.

A similar positive correlation between the value of the dollar and returns of ADRs is suggested in an article by Byrne (January 16, 2004). Byrne analyzes price movements in ADRs based on the U.S. Dollar exchange rate. He criticizes those analysts that recommend buying ADRs in times of falling dollar. Byrne states that this strategy has a downside risk. He refers to companies like the German software maker SAP that had reported lower exports and revenues, and thus lower prices for ADRs as a result of weaker U.S. Dollar.

THE DOLLAR/ADR RELATIONSHIP

ADRs are U.S. Dollar denominated forms of equity ownership in foreign companies. They represent foreign shares of a company held on deposit by a custodian bank in the company’s home country. ADR carries the corporate and economic rights of the foreign shares and can be traded for the foreign underlying share. Because of the transparency of ADRs, it is said that there are arbitrage opportunities available to investors when currency exchange rates fluctuate. For example, if investors buy an ADR they have the option to exchange the ADR for the underlying foreign share and sell it in the foreign market for the foreign currency. Investors would then convert the currency back into U.S. Dollars. This series of exchanges can prove to be beneficial to the investor if the value of the U.S. Dollar drops after they purchase the ADR in the home market. An arbitrage opportunity could possibly arise because the investor would be able to sell the share and receive the foreign currency that has appreciated therefore receiving more U.S. Dollars for the share than they originally paid without the price of the ADR changing from the original value. Based on this arbitrage opportunity the prices of ADRs should adjust to reflect a change in the value of the U.S. Dollar. This implies an inverse causal relation from the value of the dollar to prices of ADRs.

However, an opposite effect of the depreciation of the dollar on ADR performance may exist when the underlying foreign company exports to the US. When the U.S. Dollar depreciates, the price of the foreign exports to the U.S. increases which may result in lower demand for the company’s products, lower sales and earnings, and thus lower prices for ADRs. As was shown in the last two articles in the previous section, several foreign companies that export to the US have reported that a depreciating U.S. Dollar has had a negative impact on their revenues and prices of their ADRs. In short, at times, weaker dollar may cause a decline in ADRs prices.

In addition, other factors not pertaining to exchange rate fluctuations may influence the performance of ADRs. In general, all internal factors within the underlying foreign company that the management can control as well as all external factors that are out of the control of the company’s management will have significant influence on company’s earnings and therefore its ADR’s price. The quality and the price of the product, the level of technology, and productivity and success in cost minimization efforts compared to rivals are some important internal factors that affect revenue, cost, and thus earnings and stock price. In addition, internal company risks such as company operating scandals and overstatement of financial performance may also be associated with ADR performance. Moreover, the performance of an ADR may also be susceptible to external risks such as interest rate fluctuations, and changes in foreign government regulations and taxes.

The value of the dollar is among many variables that influence ADR prices. Even if we assume no change in other influencing variables, the causal relation from the value of the dollar to prices of ADRs may be negative at times and positive at others. Therefore, the supposal by studies reviewed in this paper that a stable positive or negative relationship between the value of the dollar and ADR returns exists seems to be inadequate and misleading. In contrast, in this paper we hypothesize that the relationship between the value of the dollar and returns of ADRs should be insignificant.

METHODOLOGY AND TEST RESULTS

Daily data from February 11, 2002 to March 1, 2004 were used for each exchange rate: the Swedish Krona, the British Pound, the Euro, and the Japanese Yen. Over the same period, we collected daily data for the Bank of New York ADR Indices for the Swedish ADRs (BKSN), British ADRs (BKGB), Euro zone ADRs (BKEUL), and Japanese ADRs (BKJP). The exchange rates were quoted in U.S. Dollars in order to analyze the value of the U.S. Dollar against each foreign currency. The data were used for regressions in Eviews as undated data to adjust for weekends, holidays, and any other day that the U.S. market was closed. The first test applied to the data was the Dickey-Fuller test. This is a test used to determine if the data are stationary or non-stationary.

Table 1 displays the test results. As is seen, all of the variables are non-stationary since all of the slopes’t-statistics are greater than or equal to 1. Based on these results, the regression tests were applied to the first differences. Next, we regressed each ADR index against the corresponding exchange rate to determine whether or not there was a significant relationship between the ADR performance and the international value of the U.S. Dollar. The exchange rates are quoted in different sized fractions of the U.S. Dollar, and the ADR indices are capitalization-weighted and adjusted for free-float utilizing the Dow Jones’ current methodology. In order to standardize the scales for the data, the first differences of logarithms of the indices and the exchange rates were used. For each index and the corresponding exchange rate, there were a total of 513 observations. The first regression for each currency was run using all 513 observations (2/11/02-3/01/04) to detect whether or not the relationship between the performance of ADRs and the value of the U.S. Dollar was significant over the entire sample period. Next, the data were broken down into seven sub-periods to see if there was any significant relationship during shorter periods of time.

Tables 2, 3, 4 and 5 display the regression test results. The absolute values of all t-statistics are below the 5% critical t value (1.96) implying that there is no significant relationship between ADR performance and the value of the U.S. Dollar. Similar results are shown for all sub periods in each table except for the 4/25/03-8/11/03 sub-period in table 3 and the 8/12/03-11/25/03 sub-period in table 4. For these sub-periods, although t-statistics are outside the critical range, the corresponding very low adjusted R-Squared figures imply very weak relationship. These results confirm that there is no significant relationship between ADR performance and the value of the U.S. Dollar.

In support of our regression results we applied Granger Causality tests to our data. The results are displayed in table 6. All but one F-statistics are below the 5% critical F value of 4.24. The F value corresponding to the Swedish Krona (4.329) barely exceeds the critical F value. These results also conform well to our hypothesis that no causal relation from the value of the Dollar and ADR returns should exist.

CONCLUSION

In this paper, we have provided logical and empirical analyses on the relationship between ADR returns and the value of the Dollar. We have shown that the value of the Dollar has no significant explanatory power to predict ADR returns. Our results contradict some studies reviewed in this paper that hypothesize a causal relation from the Dollar to ADR returns. Our empirical analysis consisted of the Dickey-Fuller test, simple regressions, and the Granger Causality test.

This study has important implication for investment in ADRs. It illustrates the pitfalls in basing analysis on a hypothesized negative causal relation from the Dollar to ADR returns without considerations of the possible positive causal relation as well as the impacts of other internal and external factors on ADR returns.

REFERENCES

Bin, Feng-Shun, Dar-Hsin Chen, and Lloyd P. Blenman (2002), Valuation Impact of Currency Crises: Evidence for the ADR market International Review of Financial Analysis.

Byrne, Rebecca (2004), Weak Dollar Bedevils ADRs The Street.com.

Cohen, Rachel (2003), ADR Report-ADRs get boost from Motorola, stronger dollar Reuters News Service.

Kim, Minho, Andrew C. Szakmary, and Ike Mathur (1999), Price Transmission Dynamics Between ADRs and their Underlying Foreign Securities Journal of Banking and Finance.

Kwon, Taek Ho, Sung C. Bae, and Jay M. Chung (2003), Do Foreign Investors Price Foreign Exchange Risk Differently than Local Investors? Evidence from American Depositary Receipts.

Reuters News Service (2004), ADR Report-European ADRs lower as stronger dollar, oil weigh Forbes.com.

CHRISTINE MUELLER, EMILY BACHMAN & FARZAD FARSIO

Montana State University-Billings, Billings