Political risk and ADR returns: diversification in the Indian sub-continent.

Author:Dania, Akash
Position::American Depository Receipts


Terrorism, an important component of Political risk as a possible determinant of ADRs (American Depository Receipts) returns have received little attention in academic literature. To address this issue and examine whether political risk is a major determinant of ADR returns of emerging market countries, this paper empirically examines market valuation of Indian ADRs around acts of terrorism. Using a sample of 52 such events in the sample period Jan 2003--Dec 2003 we empirically analyze returns of Indian ADRs. The results from our study indicate a marginally negative significant effect, failing to indicate that event of terrorist attacks severely affect the Indian ADRs listed on the U.S. stock market. This may be explained by a combined effect of; (a) the optimism of U.S. investors towards emerging markets, and (b) market participants becoming more resilient and making informed choices around the "general" events of terrorism.

Keywords: ADRs; Terrorism; Event Study Methodology


Despite the demonstrated benefits to international diversification, there are limits to these gains because of barriers to investing overseas. Such barriers include legal, informational and economic impediments that serve to segment domestic capital markets and deter investors seeking to invest internationally. For example, lack of liquidity, currency controls, tax regulations lack of adequate information can significantly increase the perceived risk of foreign securities. Although, U.S. investors can always buy foreign securities in their home markets, one problem is that it can be carry steep transaction costs. American Depository Receipts (ADRs) is one of the options which mitigate these barriers to a large extent. ADR is a dollar-denominated negotiable certificate traded on the U.S. exchange, allowing U.S. investor equity in a foreign registered company. Besides the opportunity for international portfolio diversification (Alaganar and Bhar 2001), the ADRs offer U.S. investors an easy alternative to a direct purchase of stocks of these companies listed on foreign stock exchanges. This mitigates the problem associated with complex and expensive international security transactions and on many occasions' restrictions on accessibility to foreign markets (Jayaraman et al 1993; Arnold et al 2004).

Due to the rapid growth in the ADR market; ADRs continue to draw attention of practitioners and academicians. Several studies have investigated the determinant of ADR valuation. It is suggested that in addition to the U.S. stock market beta, ADRs are also driven by are driven by the risk stemming from their respective domestic markets. Although several studies have well documented the role of economic and financial variables (both country specific and firm specific) as important factors in explaining the ADR returns, little has been done to investigate their responses to political risk. Specifically, events related to terrorism, a major component of political risk in any country is not examined in the ADR valuation literature. Whereas political risk is generally accepted as a relevant determinant when considering investment analysis, there is little research which examines relation between political risk and market returns.

To address whether political risk is a significant determinant of ADR returns in emerging market countries, we examine market valuation of ADRs around events of terrorism. According to Chen and Sims (2004); acts of terrorism are an unfortunate part of the daily life and by nature unanticipated, therefore these are an unbiased source of political risk originating from a country which are not anticipated by the market participants.

The purpose of this paper is to investigate whether acts of terrorism in an emerging market country has any effect on the market returns of ADRs from the country where these acts were committed. It is important to answer whether, the act of terrorism at all affect ADR markets? Do market participants view the impact of a terrorist attack permanent or transitory? There are several studies which analyze the reactions of market participants to the releases of public information, such as earnings announcements (for e.g. see Daniel et al 1998; Fama 1998). However, little is documented regarding how market participants react towards an event with a high degree of uncertainty and if the market sensitivity to these crises events diminish over time?

We use India as a case of an emerging market for our study. India has emerged as a dominant Asian market due to the Indian government's "credible attempt" towards economic reforms laid in the industrial policy of 1991 (Bhattacharya and Palaha 1996). Besides a well developed financial system which includes a rapidly expanding capital market and a diversified industrial base; India offers a democratic set-up with steady growth, a single digit inflation rate, vast internal market, and large pool of trained and educated manpower to the global investor. According to the Indiresan (2004); on the basis of Purchasing Power Parity, India ranks as the fourth largest economy in the world; with prospects overcoming Japan in next five years. At the present growth rate, India should overcome the US in next 30-40 years. Given the newfound interest in the Indian Stock Market it is important to examine the international investor expectations towards investment in the Indian firms. Practitioners will also find the case of India as an ideal laboratory to test results for the choices of international investment opportunities, especially with little potential of diversification in highly correlated capital markets of developed countries.

Specifically, this paper is interested in analyzing whether; acts of terrorism in India have any effect on the returns of Indian ADR listed at the U.S. stock exchange. In information-oriented financial markets, news travels fast and contagion spreads quickly. The results from our study indicate a marginally negative significant effect, failing to indicate that event of terrorist attacks severely affect the Indian ADRs listed on the U.S. stock market. This indicates investors in the U.S. financial markets may have become by nature more resilient to "general" events of terrorism; and wait to act only when convinced on the severity of attack(s). The rest of the paper is organized as follows: section 2 details a commentary on relationship between political uncertainty and stock prices; in section 3 we present the details on methodology and data set used for our research; finally in section 4 we present the results and conclusion.


Security prices incorporate investor's over and under-reaction regarding anticipated events in future, and when aggregated, can generate a substantial variability in security prices. According to Chen and Siems (2004), the reasons for volatility may be attributed to the nature of financial assets and their liquidity. In an event of a catastrophic and unanticipated event such as terrorist attack, investors often sell their positions in associated stocks for a safer investment. According to Indiresan (2004) macro-economic stability is important for a continued growth of any economy. An event such as a terrorist attack is likely to have a negative effect on macro-economic activity and consequently on the financial market of the country where the event takes place.

On an aggregate scale, business cycles and stock market volatility has been characterized due to irrational exuberance and pessimism (Chateauneuf et al, 2003). According to Calvo and Mendoza (2002) globalization adds to volatility in stock prices. Several highly diversified investors fail to pay attention to economic fundamentals, rather they exhibit herd behavior in the presence of any asymmetric information. The asymmetric information may be concerning events associated to political uncertainty, such severity and possible consequence of a terrorist attack. According to Kaminsky and Schmukler (2002), for the reasons of severity of asymmetric information and general lack of transparency surrounding these events in emerging markets, rallies or downturns in stock prices is likely to be stronger. Of several reasons for strong asymmetry, which distort the decision making process of international investors in emerging markets are: (a) political institutions in most emerging markets are only recently making a transition to democratic process, and generally lack the checks and balances of a functional democracy; (b) constantly emerging political scandals provide signals to investors that are contrary to confidence; and, (c) information processing originating from these countries may not be efficient and correct.

When individual U.S. investors want to invest money in stocks of emerging market economies they typically turn to mutual funds to reduce their exposure to risk in investing in an unfamiliar market. However, most institutional investors can only hold investment grade instruments (i.e. securities with ratings above a certain threshold). Therefore any changes in ratings, downgrading or upgrading, may have significant impact on prices (Kaminsky and Schmukler 2002) as following an event of political instability such as a terrorist attack. Downgrading in rating of investment in a country due to political instability may follow with change in belief among investor with regards their investment position in that countries funds and prompt them sell their position in the affected country. Political instability is known to have strong adverse effect on economic prosperity. In their economic evolution of a counterfactual Basque country without terrorism compared to the actual experience of the Basque Country Abadie and Gardeazabal (2003) conclude a decline of 10 percentage points in GDP of the actual Basque Country facing terrorism compared to the counterfactual region. They also study the effect of a 1998...

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