LOST IN TRANSLATION: WHICH STOCK PRICES BEAR THE BURDEN TO ADJUST TO EXCHANGE RATES?

• DOI: http://doi.org/10.1111/jfir.12098
• Date: 01 September 2016
• Author: Larry Lockwood,Jimmy Lockwood,Sie Ting Lau
• Published date: 01 September 2016

LOST IN TRANSLATION: WHICH STOCK PRICES BEAR THE BURDEN

TO ADJUST TO EXCHANGE RATES?

Jimmy Lockwood

Colorado State University

Larry Lockwood

Texas Christian University

Sie Ting Lau

Nanyang Technological University

Abstract

We examine the role of competing exchanges to restore price parity following currency

shocks during 2008, a year characterized by dramatic currency volatility. Burdens on the

NYSE and home market to restore price parity for cross-listed stocks are more dynamic

than previously thought. Adjustments in NYSE prices are not uniform across stocks, are

often less than home market adjustments, and are strongly influenced by differences in

order execution quality. We quantify the effect of currency shocks using a three-system

error correction model, and show that currency shocks exert independent and profound

effects as prices gravitate to restore price parity.

JEL Classification: G01, G15, G19, G30

I. Introduction

The efficient markets hypothesis assumes that security market prices rapidly reflect new

information, making it difficult to “beat the market.”However, the efficient markets

hypothesis is agnostic regarding precisely where new information is first reflected for

securities that trade in more than one marketplace. Though there are many studies of

international cross-listing in the United States, little attention has been given to the

informational role of exchange rates in the price-formation process.

1

In the absence of arbitrage restrictions, the law of one price suggests that the two

securities be priced identically, at all points in time, after adjusting for exchange rates.

However, exchange rate shocks might exert independent effects on stock prices, and the

effects may be asymmetric for the home and foreign markets. There is no a priori reason

We gratefully acknowledge Eric Powers, Steve Mann, Tim Koch, Pete Locke, Sanjiv Sabherwal, Joachim

Grammig, Tom McInish (referee), P. K. Jain, Cheol Eun, Rick Harris, John Elder, Harry Turtle, Bill Crowder, Mo

Rodriguez, Martin Herrera, Scott Hein (editor), Christopher Neely (associate editor), and participants in seminars

at The University of Memphis, Texas Christian University, The University of Texas at Arlington, Colorado State

University, and The University of South Carolina for many helpful suggestions on previous drafts of this paper.

1

See Karolyi (1998, 2006) for comprehensive reviews of the literature relating to international cross-listings.

The Journal of Financial Research Vol. XXXIX, No. 3 Pages 263–290 Fall 2016

263

© 2016 The Southern Finance Association and the Southwestern Finance Association

RAWLS COLLEGE OF BUSINESS, TEXAS TECH UNIVERSITY

PUBLISHED FOR THE SOUTHERN AND SOUTHWESTERN

FINANCE ASSOCIATIONS BY WILEY-BLACKWELL PUBLISHING

prices should automatically meet in the middle, or for one market to bear the entire

burden of adjustment.

Our main objective is to add to the understanding of how prices on competing

markets gravitate to restore the law of one price following exchange rate shocks. We ask

the following questions. For stocks trading simultaneously on the NYSE and home

country markets, does the NYSE bear all of the burden to adjust when restoring price

parity following currency shocks? To what extent do prices change to restore price parity

following currency shocks? Are effects similar within country, or are they stock specific?

And to what extent are exchange rate effects driven by order execution quality?

We choose three home markets characterized by different degrees of financial

development, investor protection, insider trading law enforcement, and liquidity, yet

with significant intraday trading overlap. Our rationale is that characteristics of the

domestic and foreign countries should be correlated with trading characteristics, such as

trading costs, trading volume, and price impacts, and, therefore, should provide robust

tests of adjustments to exchange rate changes. Specifically, we assess the impact of

exchange rate shocks on U.S. and home market prices for 46 cross-listings on the NYSE

from Canada, Brazil, and Mexico during 2008, one of the most volatile periods for stocks

and currencies in recent history. For example, during the last third of 2008, the U.S. dollar

rose over 15% relative to the Canadian dollar, 32% relative to the Brazilian real, and 30%

relative to the Mexican peso, and daily standard deviations increased by multiples of 3.3,

4.5, and 6.3, respectively. The unusual volatility offers a textbook case study of how

prices on competing exchanges move to restore price parity.

Previous studies include Grammig, Melvin, and Schlag (2005a) who examine

three German stocks cross-listed on the Frankfort Stock Exchange and the NYSE from

August 1999 to October 1999. The authors show most of the exchange rate burden is

borne by the NYSE and conclude that the foreign investor “is subject to exchange rate

risk in that prices incorporate another source of uncertainty beyond the value of the firm

itself, and this is not the case for the home-market investor (p. 162).”

2

Similarly, Eun and

Sabherwal (2003) show that the NYSE bears most of the burden to adjust to exchange

rates for their portfolio of stocks cross-listing to the United States from Canada. More

recently, Frijns, Gilbert, and Tourani-Rad (2010) examine exchange rate effects for nine

bilaterally cross-listed stocks between Australia and New Zealand, and find that the

foreign market bears most of the burden to adjust to exchange rates. These studies offer

insights into the role of exchange rates and conclude that the burden of adjustment to

exchange rate changes resides with the foreign market.

Our article differs from earlier studies by examining exchange rates effects over

volatile currency periods, multiple markets, and larger stock samples characterized by

2

The primary focus of Grammig, Melvin, and Schlag (2005a) is to offer simulations showing that volatile

exchange rates can have dramatic effects on Hasbrouck (1995) information shares. Their simulation shows that

inferences depend on whether the home market currency is converted to the foreign currency or whether the foreign

currency is converted to the home market currency, and that the errors in inference increase with the volatility of

exchange rates. In a related paper, Grammig, Melvin, and Schlag (2005b) examine 17 stocks cross-listing to the

United States from the United Kingdom, France, Germany, and Canada during 1999, and show that most of the

burden of cross-listing prices to adjust to exchange rates resides with the United States for their sample.

264 The Journal of Financial Research