Financial investment via ADRs in Mexico and South America

Abstract

American depository receipts (ADRs) are dollar-denominated, negotiable instruments issued by a depository bank to represent ownership of a foreign security in the bank's possession. They are the primary method employed by Latin American corporations to raise equity capital in the United States. One flequently overlooked aspect about ADRs is that their investment performance provides a gauge not only on management's performance but also a measure of the foreign government's ability to provide a political, legal, economic and social climate that is conducive to international investment. This paper investigates the returns and risks associated with foreign investment in Mexico and South America. First, we show that the weekly returns to Latin American stocks are weakly correlated with the U.S. stock market which suggests that they can reduce the risk of a portfolio that is fully diversified within the U.S. market. Second, we find that ADRs from this region are more risky than U.S. common stocks. However, we find little evidence that foreign exchange rate risk should be a major factor in the investment decision. Third, we examine the effects of the devaluation of the Mexican peso and show that political factors can significantly increase the risk and reduce the return to foreign investment. Finally, the results show that investors do not pay a significantly larger relative transaction cost premium for investing in Mexican and South American equity vis-à-vis U.S. common stock. We conclude that ADRs provide the ability for the U.S. investor to realize potentially superior gains from companies located in these emerging economies. However, the willingness by the U.S. investor to disinvest means that politicians and managers have a powerful incentive to continue reforms that lead to improved standards of living for their citizens and employees.