Gita Swamy & Lama Mansour

IFM Paper: MBA Class of 2006

Arbitrage Opportunity between Indian stocks and

their ADR’s

International Financial Management

By

Gitanjali Swamy & Lama Mansour

MBA Class of 2006

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Gita Swamy & Lama Mansour
IFM Paper: MBA Class of 2006

Arbitrage Opportunity between Indian stocks and

their ADR’s

Introduction
There continues to be a tremendous opportunity for growth and investment in the Indian
subcontinent. Both the Bombay Sensex and the Nifty indicies have significantly outperformed
the DJIA and the S&P. For example while the S&P has increased by 40% over the last two
years, the Sensex has increased by over 100%. However, even though the Indian market
provides a compelling opportunity for investment, it is difficult for foreign investors to access
this market directly. Thus, Indian companies’ ADR’s are a valuable investment for US
investors. While the law of one price states that two identical securities must be priced
identically, Indian ADR’s tend to be priced at a premium to the underlying stock. Therefore,
there is significant arbitrage opportunity between US traded ADR’s and the corresponding
Indian stocks. This paper examines this arbitrage opportunity.

We first examine the reasons for ADR-stock differences and then build an investment thesis
around ADR arbitrage. In future work, we will use this thesis to execute trades and evaluate
the performance of the thesis over a 3-6 month time horizon. We are restricting the thesis to
the 160 Indian stocks that have US ADR’s.

Background

2.1 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
shares on deposit with a custodian in the issuer’s home market. So for example, 1:10 means
that 1 depository receipt or 1 certificate = 10 ADSs (American Depository Shares in the local
company).

ADR’s 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.

2.2 Types of ADR’s

There are several types of ADR’s which we describe below:

• Unsponsored shares: These are ADR’s that trade in the OTC market. They are
issued according to market demand and have no regulatory reporting requirements.
These ADR’s are no longer traded.
• Sponsored ADR’s: All ADR’s (Level 1, 2, 3, Rule 144a) are sponsored ADR’s. 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

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company (please see section below ‘Parties Involved’ to understand mechanics of

sponsored ADR’s)

• Level1 ADR’s: Over the counter through the OTC bulletin board or the Pink Sheet
listed on a US exchange. Level 1 ADR’s 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.

• Level 2 ADR’s: These are exchange traded ADR’s 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 ADR’s. The issuer must comply with
the regulations of the SEC and the appropriate exchange.

• Level 3 ADR’s: These are ADR’s 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 ADR’s: 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 ADR’s.

ADR’s allow US investor’s to diversify into international equity.

2.3 Benefits to U.S Investors

• Access and Diversification: ADR’s 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 ADR’s.
• Liquidity: The liquidity of ADR’s makes them attractive instruments for U.S investors who
wish to invest in companies outside their home market.
• Safety and Transparency: U.S investors have greater access to company research, and
price and trading information. Additionally trading, clearing and settling of trade’s takes
place in accordance to U.S market regulations. Dividend payments are paid in $US and
corporate action notifications are made in English.
• Comparability: U.S investors can easily compare U.S securities with ADR’s
• Lower tax rates on dividends: Investors may benefit from lower tax obligations on
dividends made by issuers of exchange listed ADR’s in cases where there is a treaty
between U.S and issuer’s local market.

2.4 Benefits to Issuers of ADR’s

• 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.
• Branding: Indian companies can raise their profile internationally
• Increase local price: As a result of global demand, local prices may increase

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IFM Paper: MBA Class of 2006

• M&A and corporate action activity: Increase merger and acquisition activity by allowing
the issuer to use ADR’s as acquisition currency. Additionally, ADR’s 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.

2.5 ADR Structure

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

2.6 Parties and Transactions

Figure 1. ADR Parties
Investment Bankers
Brokers

Depositary Issuer Lawyers

Custodian Accountants

Source: Citigroup Depositary Receipt Services Report 2005

2.6.1 Issuer Company

• Selects lawyers, investment bankers and accountants and seek approval from
board of directors as needed.
• 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.
• Selects and signs exclusive agreement with a depositary bank in U.S.

2.6.2 Depositary Bank

• Appoints custodian bank in India.
• Advises on DR structure and registration requirements.
• Prepares and issues ADR’s.

2.6.3 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

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IFM Paper: MBA Class of 2006

2.6.4 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.

2.6.5 Lawyers
• Negotiate deposit agreements; prepare listing agreements to list on appropriate
exchanges.

2.6.6 Accountants
• Prepare financial statements in accordance with U.S GAAP.

2.6.7 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

Figure 2. Transactions in Creating an ADR

Investor

7 1
2
Local
DR Broker Broker
3

Clearing Local Stock

Market
6 4
Depositary Local
Custodian

Source: Citigroup Depositary Receipt Services 2005

2.7 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.

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IFM Paper: MBA Class of 2006

6) The depositary bank issues ADR’s and delivers them in physical form through the
DTC
7) The broker delivers the ADR’s to the investor or credits the investor’s accounts.

Figure 3. Performance of Indian ADR’s

Index 200

Indian
180

Indian IT Companies
160
BSE

140
NASDAQ

120
Indexed Price

100

80

60

40

20

0
4/30/04 7/22/04 10/11/04 12/30/04 3/22/05

Indian ADRS Indian IT BSE NASDAQ

% Off High (19.9%) (19.8%) (10.7%) (11.5%)
% Off Low 60.7% 55.4% 39.9% 10.1%
Index value on 5/2/05 143.38 123.89 110.15 100.44
Source: Jefferies

Indian Companies that Issue ADR’s

There are 169 Indian companies in total that issue ADR’s. Only 10 of the 169 issue ADR’s
that are listed on a US exchange. The others trade OTC. Important ADR’s include Infosys,
Wipro and ICICI. As shown in Figure 3., Indian ADR’s have significantly outperformed Indian
IT companies, the BSE and the NASDAQ composite.

3.1 Companies
The following 10 Indian companies issue ADR’s that are listed on a US exchange.

Figure 4. Top Indian ADR’s

RATIO
ADR SYMBOL EXCH ADR: INDUSTRY
ORD
DR. REDDY'S LABORATORIES LTD. RDY NYSE 1:1 Pharmaceutical
HDFC BANK LTD. HDB NYSE 1:3 Banks

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IFM Paper: MBA Class of 2006

ICICI BANK LTD. IBN NYSE 1:2 Banks

INFOSYS TECHNOLOGIES LIMITED INFY NASDAQ 1:1 Technology
Services
MAHANAGAR TELEPHONE NIGAM MTE NYSE 1:2 Fixed Line Comm.
LIMITED
REDIFF.COM INDIA LTD REDF NASDAQ 2:1 Technology
Services
SATYAM COMPUTER SERVICES SAY NYSE 1:2 Technology
LIMITED Services
SIFY LTD. SIFY NASDAQ 1:1 Technology
Services
TATA MOTORS LTD. TTM NYSE 1:1 Auto Manufacturers
VIDESH SANCHAR NIGAM LIMITED VSL NYSE 1:2 Fixed Line Comm.
WIPRO LTD. WIT NYSE 1:1 Technology

3.2 ADR Arbitrage

ADR’s can sometimes trade at a big difference to the stock in its home market. This is a
violation of the Law of One Price, which states that two securities with the same payoffs
must have the same price. Therefore it is important to either justify why the ADR does not
have the same price as the underlying stock or establish an arbitrage strategy that allows us
to capitalize on this imperfection.

Figure 5. US vs. Indian Stock Comparables

Total Enterprise Value / TTM Revenue
IT Consulting
Internet Media Telecom Media Banking
& Services

6.90x
15.70x 1.89x
6.4
3.6
1.
38 1. 1.
11.40x 16 60
1. 11
3.1 4.0
45 .5
0x

1.30x

0.60x

Yahoo Rediff.com Allegiance VSNL Accenture Wipro The Liberty Zee Telefilms SunTrust ICICI
Telecom Corporation

Source: Jefferies

This phenomenon has been studied in several international markets. In the Canadian market,
the arbitrage led to price-discovery. In the Israeli, Mexican, UK or Australian markets, there
were no opportunities for arbitrage as prices were similar. In contrast the Indian market has
an unusually high opportunity for ADR price arbitrage. Bellweather Indian ADR’s such as
Infosys, Satyam and Wipro have all consistently traded at 30-130% premium over the
domestic stock.

It is worth examining other countries’ ADR’s to identify potential causes for ADR price
differentials. Rabinovitch and Silva (ref) examined the effects of fixed exchange rates, capital
restrictions in Chilean and Argentinean ADR’s. They concluded that based on statistical

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evidence, a spread of 1.14% in Argentina and 1.37% in Chile was necessary before there
would be an opportunity for arbitrage. Both Argentina and Chile are in the same time zone
and hence the effects of time-differentials on the spread would be minimal.

Eun and Sabherwal examined Canadian ADR’s trading in the US market and concluded that
price differentials between the ADR and the underlying Canadian stock are affected by
relative trading characteristics, for example ratio of trades in the two markets.

Figure 6. Performance of Indian ADR’s wrt Stock

Infosys
$84

$74

$64

$54 39%
$44

$33

$23

$13
4/30/2004 6/14/2004 7/26/2004 9/3/2004 10/15/2004 11/26/2004 1/7/2005 2/18/2005 4/4/2005

Satyam
$37

$32

$28

$24

$19
128%
$15

$10

$6
4/30/2004 6/14/2004 7/26/2004 9/3/2004 10/15/2004 11/26/2004 1/7/2005 2/18/2005 4/4/2005

Wipro
$32
ADR’s
$28
Indian Listed
Stock $24

$20

$17
29%
$13

$9

$5
4/30/04 6/14/04 7/26/04 9/3/04 10/15/04 11/26/04 1/7/05 2/18/05 4/4/05

Source: Jefferies

3.3 Reasons why ADR’s are overpriced

There are several reasons that explain why Indian ADR’s trade at a premium to the stock.
• There is excess demand for Indian high growth companies that list on the US market.
• There is also a limited supply of ADR’s. Typically, ADR’s represent only 3% - 6% of
the market capitalization of a stock.
• There are few opportunities in the US to invest in companies that are growing at the
20–30% rate that Indian IT stocks are growing at. It is hard for US companies to enter
the Indian market due to the dynamics of regulation and Indian politics. Typically
Indian technology companies trade at higher valuation multiples as compared to US
comparables (Figure 5).

• The Indian stock market is characterized by lower trading volumes and liquidity levels
compared to the US markets. In fact only 50 stocks in the Indian market have trading
volumes of more than 500,000 shares.
• ADR’s also provide a value added layer – transparency, liquidity and greater
coverage than the existing Indian stock.
• Finally, until very recently there have been currency controls in India. While the
Indian Rupee is not freely convertible yet, there is more convertibility available today.

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3.4 Reasons why some ADR’s are under priced

Conversely there are reasons why ADR’s could be under priced.

• If the costs of investing in the ADR’s are more than the risk of entering the market
directly, then the ADR’s should trade at a discount. Examples are ADR’s in
developed countries such as Switzerland. But this situation does not apply to India
since it is still on the threshold of development.

• The Indian local exchange does not provide easy access to foreigners. The foreign
institutional investors’ (FII) equity holdings in a single company are capped at a level
below the overall sector-specific foreign investment limits. Furthermore, FIIs investing
in India's capital markets must register with the Securities and Exchange Board of
India (SEBI).

We believe that Indian ADR’s are sufficiently mis-priced in spite of the reasons listed and we
hope to arbitrage the mispricing and create a synthetic security/scheme to exploit this.

3.5 Establishing Quantitative estimate for Indian market ADR premium

To summarize, we’ve identified the following determinants of the ADR price differential:

1. Price/value
a. ADR: Price of ADR or Padr
b. Stock: Price of home country stock: Pstock
c. Market Index (NYSE, Nasdaq, OTC, Sensex, BSE): Mnyse, Mnasdaq, Motc,
Msensex, Mbse
2. Volume
a. ADR: Volume of ADR traded daily or Vadr
b. Stock: Volume of Stock traded daily or Vstock
c. Market: Total market volume – Vnyse, Vnasdaq, Votc, Vsensex, Vbse
3. Currency
a. Convertibility/Control: CC
4. Sovereign spread: The sovereign spread should embody all the country specific
differences. Thus, the ADR spread must be greater than the sovereign spread: SS
5. Foreigner restrictions: FR
6. Tax/Capital Gains Rate
a. US: Tu
b. India: Ti
7. Dividend yield: Ystock
8. Transparency and regulation requirements: Tr

We believe that the ADR spread could be modeled as a regression function

a. DeltaP = Padr - Pstock or Padr / Pstock = F(Padr, Pstock, , Mnasdaq, Motc, Msensex,
Mbse, Vadr, Vstock, Vnyse, Vnasdaq, Votc, Vsensex, Vbse, CC, SS, FR, Tu, Ti, Ystock,
Tr)

While there may be some argument as to the linearity of the regression, we believe that it
makes sense to start with a linear multivariate regression.

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IFM Paper: MBA Class of 2006

Experiment
As retail investors, we can arbitrage Indian ADR differences but we cannot follow the
Institutional Route to arbitrage ADR’s. This route is the following:

Traditional Strategy:

1. Buy Indian stock on the Indian market,

2. Create and sell various degrees of ADR’s (unsponsored…Level III)
3. Sell them on the US OTC, NYSE markets.
4. Repeat strategy

An alternate trading strategy would be to compute the allowable spread based on a

multivariate regression analysis and trade only if the actual spread exceeds the predicted
spread suggested by the regression.

Retail Strategy:

1. Compute DeltaP = Padr - Pstock or Padr / Pstock = F(Padr, Pstock, , Mnasdaq, Motc, Msensex,
Mbse, Vadr, Vstock, Vnyse, Vnasdaq, Votc, Vsensex, Vbse, CC, SS, FR, Tu, Ti, Ystock, Tr)

2. If DeltaP < Actual Spread

a. Buy Indian stock and short the US ADR.

3. If DeltaP > Actual Spread

a. Short Indian stock and buy the US ADR.

In both cases, our overall portfolio should increase as long as the differential persists.

We ran a simple regression with available data, which included the Price of stock (Pstock), the
trading Volume of the ADR (Vus) and the dividend yield (Yus). The regression gave a 0.94
correlation coefficient, which is very high proving that there is a strong relationship between
the ADR spread and the dependent variables such as price , yield, volume etc.

Figure 7. Results of Regression on ADR Stock Spread

Regression Statistics
Multiple R 0.94695162
R Square 0.89671737
Adjusted R Square 0.834747793
Standard Error 8.995631021

According to our preliminary experimental results with limited data sets:

Spread = 7.22 + 0.2225*Pstock + 7.9808E-06 *Vus - 17.25*Yus

If instead of the difference (spread), we modeled the ratio of Indian ADR value to underlying
stock, we get a correlation coefficient of 0.72.

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IFM Paper: MBA Class of 2006

Figure 8. Results of Regression on ADR Stock Ratio

Regression Statistics
Multiple R 0.723083472
R Square 0.522849708
Adjusted R 0.236559533
Standard E 0.676558753

The corresponding equation for the predicted ratio of ADR price to underlying stock price is

Ratio % = 1.817 - 0.000366*Pstock + 4.5161E-07*Vus - 0.5980*Yus

If we plug a price of Rs 2500 for Infosys, which has no dividend and trades at ADR volumes
of 56500 shares, the regression suggests that its ADR should not trade at over 14% premium
over its underlying stock.

Conclusion
We examined ADR’s, their structure and the parties involved in ADR’s. We have explored
Indian ADR-underlying stock price differentials and hypothesized several reasons for their
existence. We’ve also compared the Indian with ADR arbitrage in other countries. Finally, we
have developed a simple formula and scheme to arbitrage the ADR-stock price differential if
the opportunity exists.

Our regression analysis was preliminary and limited by lack of a sufficient volume of data on
the Indian stock market. While the analysis showed trends, we do not have enough data on
the Indian market for the regression analysis to be statistically significant. The next steps of
this research would to be to collect more rigorous data, implement a program to directly
extract it in real time from trading databases and then implement a robust trading scheme to
demonstrate portfolio results.

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References
1. Mihir Desai, Maria Raga-Frances, Ami Dave, Mark Veblen and Kathleen Luchs,
“Cross Border Listings and Depository Receipts“, Harvard Business School Case 9-
204-022, January 2004.

2. http://wwss.citissb.com/adr/www/ Citigroup Depositary Receipts Websites.

3. http://www.adr.com/entry_disclaimer.html JP Morgan ADR website.

4. http://www.sharekhan.com/Services/OpenAnAccount.aspx Indian Online Brokerage

Site.

5. http://www.bseindia.com/price_finder/stockreach.asp?scripcd=500209 Bombay Stock

Exchange Website.

6. Ashok Jogani, Kshama Fernandes, “Arbitrage in India; past, present and future”,
October 2002.

7. Citigroup Global Transaction Services, ‘Depositary Receipts Information Guide’.

8. Jefferies, ‘State of the Indian Market’ 2005.

9. Blouin, Hail, Yetman, “Capital Gains Taxes, Pricing Spreads and Arbitrage: Evidence
from U.S cross- listed Firms”, June 2005.

10. Phylaktis, Korczak, “Specialist Trading and the Price Discovery Process of NYSE-
Listed Non – US Stocks”, July 2004.

11. Oppenheimer, Sabherwal, “Impact of US Decimalization on cross- listed Canadian

Stocks”, Fall 2003

12. Rabinovitch, Silva, Susmel, “Returns on ADR’s and Arbitrage in Emerging Markets,
April 2003

13. Grammig, Melvin, Schlog, “The Role of US Trading in Pricing internationally cross
listed stocks”, March 2004

14. Otaviano Canuto, Pablo Santos and Paulo Sa Porto, “Macroeconomics and
Sovereign Risk Ratings”, January 2004

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