Linear and Nonlinear Dynamic Linkages between Emerging Market ADRs and their Underlying Stocks

Abstract

I examine the causal linkages between the returns on emerging market ADRs, their underlying stocks, and changes in the relevant exchange rate. Using a linear VAR model with a cointegration constraint and a nonlinear causality test on daily data, I provide evidence of significant linear and nonlinear causal transmissions from the underlying stocks to the ADRs. Contrary to results from the industrialized markets, there are also significant causal transmissions from the ADRs to the underlying stocks for several days. In fact, the ADRs have greater predictive ability for their underlying stocks than vice versa. Price transmissions from the currency market are generally less persistent, except in the case of Mexico where there are significant bi-directional linear causality between ADRs/underlying stocks and the exchange rate. A trading strategy using the predictability of the ADRs and underlying stocks provide a large excess return relative to a buy-and-hold strategy, but this is unprofitable after accounting for transaction costs.