Fundamentals of Financial Instruments. Sunil K. Parameswaran

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СКАЧАТЬ there was a flood of issues by international mining companies on the Toronto Stock Exchange in the mid-1990s.³ This is because it was felt that Canadian investors had greater experience in evaluating shares of such firms.

      At times a firm may go in for a global issue because it perceives its domestic market to be too small for an issue of the size it is contemplating. In Europe, for example, this fact has compelled Scandinavian and Eastern European firms to access markets across their borders.

      There are two broad categories of ADR programs: sponsored and unsponsored. In the case of a sponsored program, the exercise is initiated by the foreign firm whose shares are sought to be traded in the United States. In the case of an unsponsored issue, the process will typically be initiated by an investment bank in the United States that has acquired shares in a foreign market.

FUNGIBILITY

      Fungibility means the ability to interchange with an identical item. ADRs may be one-way fungible or two-way fungible. If an ADR is one-way fungible, then a US investor can sell the ADR back to the depository in the United States and have the equivalent number of underlying shares sold in the home country. However, if the ADRs were to be two-way fungible, then an investor could also surrender shares to the custodian bank in the home country and acquire ADRs in lieu. The problem with one-way fungibility is that it makes ADRs less attractive for American investors, because it has the potential to reduce the liquidity and the floating stock of ADRs in the United States. Besides, two-way fungibility is essential to preclude arbitrage opportunities.

ARBITRAGE

      What is arbitrage? The term arbitrage refers to the strategy of making costless, riskless profits by simultaneously transacting in two or more markets. This is one of the fundamental principles underlying modern finance theory. One of the basic tenets of finance is the concept of risk aversion; that is, an investor will demand a risk premium for bearing a certain level of risk, and the higher the risk associated with an investment, the greater will be the premium demanded over and above the riskless rate of interest.

Arbitrage may be defined as the presence of a rate of return greater than the riskless rate on an investment devoid of risk or, equivalently, as the specter of a positive rate of return from a trading strategy that entails neither an investment nor an assumption of risk.

      Take the case of a city like Mumbai, which has two major stock exchanges, namely the Mumbai Stock Exchange (BSE) and the National Stock Exchange (NSE). Assume that a share is trading at INR 100 on the BSE and at INR 100.75 on the NSE. An arbitrageur will place a buy order for 500,000 shares on the BSE while simultaneously placing a sell order for an equivalent amount on the NSE. Before accounting for transactions costs, he is assured of a profit of . Considering the fact that he did not have to invest any money and was able to implement the strategy without taking any risk, such an opportunity should not exist.

      There are certain practical issues to be considered while evaluating what looks like an opportunity for free money. First, can the trader make a profit after factoring in transactions costs like brokerage commissions? Most retail investors will have to incur such expenses; however, a securities dealing firm has a tremendous advantage for it does not have to pay such transactions-related charges. Consequently, such strategies that appear infeasible for retail traders may be profitable for institutions.

      The second issue is that in this example both the exchanges have a T+2 settlement cycle. That is, if an investor were to trade on a particular day, the payment of cash to the seller and the delivery of securities to the buyer will take place two business days later. Thus, the arbitrageur cannot wait to take delivery on the BSE before giving delivery on the NSE. Consequently, to capitalize on such opportunities a potential arbitrageur needs access to a stockpile of cash as well as a long position in the security right at the outset.

      In practice such opportunities will not remain for long. As arbitrageurs start buying on the BSE the price there will be driven up by the increasing demand. Similarly, as they start selling on the NSE, the increased supply will push prices down. After a brief while such opportunities will not be apparent.

      In practice such opportunities exist for fleeting moments. They can be exploited by players who are always in the thick of the action such as financial institutions. The issue may be viewed as follows. A mispriced security offers a potential arbitrage opportunity. The possibility of making arbitrage profits ensures that securities are not mispriced in practice. To ensure that such avenues for profit are seized and exploited, traders increasingly rely on automated systems. One well-known type of arbitrage is Stock Index Arbitrage, which entails the exploitation of deviations from the postulated pricing relationship between stock indices and futures contracts based on them. This is not easy in practice, for if we take an index like the Standard and Poor's 500 (S&P), 500 constituent stocks have to be either bought or sold in the right proportions. Thus, the availability of a computer becomes imperative, and consequently the implementation of such arbitrage strategies is referred to as Program Trading.

ARBITRAGE WITH ADRs

      Mispriced ADRs will be exploited by arbitrageurs. We will illustrate this with the help of an example.

Let's assume that shares of the Indian information technology company Infosys Technologies are quoting at INR 1,500 on the National Stock Exchange (NSE) in Mumbai, and that Infosys ADRs, where each ADR represents 20 domestic shares, are quoting at $410 on the NYSE. The current exchange rate is INR 75 per USD.

      Quite obviously the ADRs are overvalued, for the dollar equivalent of 20 shares should be $400. An arbitrageur will short sell the ADRs in New York, acquiring 20 shares on the NSE for every ADR that is sold short, and then deliver them to the custodian bank in Mumbai, which will inform the depository bank in New York. On receiving intimation from Mumbai, the bank in New York will issue an ADR which can be used to cover the short position. The cost of acquisition of 20 shares in Mumbai will be INR 30,000 or $400. The proceeds from the short sale in New York will be $410. Consequently, an arbitrage profit of $10 can be earned.

      Now let's examine a situation where ADRs are undervalued. What if the price of the Infosys ADR were to be $390? If so, an arbitrageur would acquire an ADR for $390 and deliver it to the depository bank in New York with instructions to sell the underlying shares in Mumbai. The sale proceeds will amount to INR 30,000 or $400. Once again, the arbitrageur will realize an arbitrage profit of $10.

      J.P. Morgan was a pioneer in the creation of ADRs. They created the first ADR in 1927 to facilitate investment in foreign companies by American investors. An ADR is considered to be an American security, and consequently is freely tradable in the United States. It is akin to any other domestic security for the purpose of clearing and settlement.

GDRs

      While ADRs are the most common type of depository receipts, there are other similar securities called GDRs. A global depository receipt (GDR) differs from an ADR in the sense that it is offered to investors in two or more markets outside the issuer's home country. Most such issues will include a tranche for US investors, as well as a separate tranche for international investors.

      EDRs or Euro Depository Receipts represent ownership of shares in a corporation that is based in a country outside the European Monetary Union (EMU). While depository receipts are primarily issued to facilitate ownership of overseas equity, they can also be structured to permit investors to take a stake in a foreign debt issue. An American Depository Debenture (ADD) СКАЧАТЬ