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Applied Economics Letters, 2004, 11, 755–758

Foreign exchange risk, world diversification and Taiwanese ADRs
A L A N T . W A N G * and S H E N G - Y UN G Y A N G y Department of Accounting, National Cheng Kung University, No.1 Ta-Hsueh Rd, Tainan, 701, Taiwan and yDepartment of Finance, National Chung Hsing University, No.250 Kuo Kuang Rd, Taichung, 402, Taiwan

This study tries to answer the following question: Should the US investors purchase American depository receipts (ADRs) issued by Taiwanese multinationals? The conditional international asset pricing model of Dumas and Solnik (Journal of Finance, 50, 445–79, 1995) is applied to price these Taiwanese American depository receipts (ADRs). Empirical results show that foreign exchange risk is priced in Taiwanese ADRs. Moreover, Taiwanese ADRs are shown to help US investors diversify their portfolios globally. These findings suggest that Taiwanese ADRs are valid investment tools for US investors who seek international diversifications.

I . I N T R O D U C T IO N The 1980s and 1990s saw a rapid integration of international capital and financial markets. Economists have identified the potential welfare gains from market integration in terms of risk-sharing benefits, investment activity, stock market development and overall economic growth. These welfare gains will be present as long as the international markets are not perfectly correlated. From the investors’ perspective, international portfolio diversification enhances the values of the expected utilities of their future wealth, and from the firms’ perspective, financing internationally helps reduce their costs of capital. With the advent of American Depository Receipts (ADRs), US investors can achieve international diversification at home via investing in ADRs. For the past decade, many Taiwanese hi-tech firms have issued ADRs to increase their investor base and accessibility to international capital markets. Some of these Taiwanese ADRs are highly liquid in the US market. For example, Taiwan Semiconductor Manufacturing (TSM) and United Micro Electronics (UMC) have the second largest and the fifth largest ADRs in terms of share volume as of 30 June 2003.1 Owing to their unique features, investigating the risk

and return characteristics of ADRs are important for financial economists. For example, is there any arbitrage opportunity between ADRs and their underlying shares? The general finding is that, after trading costs, few arbitrage opportunities exist. (Rosenthal, 1983; Kato et al., 1991; and Wahab et al., 1992). Can ADRs help multinational firms reduce their costs of capital and help investors diversify their portfolios internationally? Empirical evidence suggests that markets react positively to the announcement of new ADR programme (Alexander et al., 1988; Foerster and Karolyi, 1999). Previous literature also suggests that gains beyond those attainable through homemade diversification have become statistically and economically insignificant (Errunza et al., 1999). Finally, because the values of ADRs are directly linked to the underlying foreign shares, ADR holders should be compensated by the foreign exchange risks. To this end, the empirical results are mixed. Some researchers found no significant foreign exchange risk premiums in equity markets while some did obtain significant results (Jorion, 1991; Dumas and Solnik, 1995; Kim et al., 2000). Given that Taiwanese ADRs play an important role for both Taiwanese multinationals and the US investors, and that no previous work focuses on the portfolio

* Corresponding author. E-mail: wangt@mail.ncku.edu.tw 1 The data are taken from Depository Receipts 2003 Half-Year Market Review, the Bank of New York.
Applied Economics Letters ISSN 1350–4851 print/ISSN 1466–4291 online # 2004 Taylor & Francis Ltd http://www.tandf.co.uk/journals DOI: 10.1080/1350485042000254629

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diversification effect and the significance of foreign exchange risk premiums in Taiwanese ADRs, these issues are investigated by using the conditional international asset pricing framework of Dumas and Solnik (1995). The model is appealing due to its capability of identifying time-varying risk premiums.

A.T. Wang and S.-Y. Yang
The optimal portfolio choice problem can be specified by the following two well-known first-order conditions: E ½Mt ð1 þ tÀ1 ÞjItÀ1 Š ¼ 1 E Mt rjt jItÀ1 ¼ 0  à j ¼ 1, . . . , m ð2aÞ ð2bÞ

I I. DA T A Taiwanese multinationals which are listed in the New York Stock Exchange including Advanced Semiconductor Engineering Inc (ASX), Macronix International Co Ltd (MXICY), Siliconware Precision Industries Co Ltd (SIPY), Taiwan Semiconductor Manufacturing Co Ltd (TSM), and United Micro Electronics (UMC) are incorporated. The MSCI world index, S&P 500 index, and Taiwan Weighted Index are used as measures of general movements of the world, US, and Taiwan stock markets, respectively. Three-month Treasury bill rates and 90-day commercial paper rates are used for risk-free rates in the US and Taiwan, respectively. The exchange rate is expressed as New Taiwan Dollar per US dollar (NTD/ USD). All the data are obtained from Datastream International.2 The data frequency is recorded daily from October 2000 to May 2003.

where Mt ¼ u0t ðÁÞ=u0tÀ1 ðÁÞ, or the marginal rate of substitution between nominal returns at time t and at time tÀ1. tÀ1 refers to the conditionally risk-free rate of interest in measurement currency for the period of time beginning at time tÀ1. The international asset pricing model specified by Equation 1 expresses Mt as the following form: " # L X li,tÀ1 rnþi,t À lM,tÀ1 rmt ð1 þ tÀ1 ÞÀ1 Mt ¼ 1 À l0,tÀ1 À
i¼1

ð3Þ Dumas and Solnik (1995) assume that the information set ItÀ1 is generated by a vector of instrumental variables, ZtÀ1, and that the time-varying coefficients, ls, are linear functions of the variables in Z. Thus, ls are given as follows: l0, tÀ1 ¼ ÀZtÀ1  li, tÀ1 ¼ ZtÀ1 i i ¼ 1, . . . , L lm, tÀ1 ¼ ZtÀ1 m ð4Þ where  and  are time-invariant vectors of weights. Defining the innovation, ut ¼ 1 À Mt (1 þ tÀ1): ut ¼ ÀZtÀ1  þ
L X i¼1

I I I . T H E IN T E R N A T I O N A L A S S E T P R I C I N G M O D E L W I T H T I ME - V A R Y I N G R I S K AND PREMIUMS The international asset pricing model of Dumas and Solnik (1995) is applied to the pricing of ADRs. The following describes the international asset pricing model given by Adler and Dumas (1983): Â Ã E rjt jItÀ1 ¼
L X i¼1

ZtÀ1 i rnþi,t þZtÀ1 m rmt

ð5Þ

where ut must satisfy Equation 2a. Thus: E ½ut jItÀ1 Š ¼ 0 Next define hit ¼ rij(1 À ut), then Equation 2b implies: E ½ht jItÀ1 Š ¼ 0 Equations 6 and 7 together imply: E ½t ZtÀ1 Š ¼ 0 ð8Þ ð7Þ ð6Þ

 à li,tÀ1 cov rjt ,rnþi,t jItÀ1  à ð1Þ

þ lm,tÀ1 cov rjt ,rm,t jItÀ1

where t ¼ (ut, ht), the 1 þ m vector of residuals. Equation 8 describes the moment condition: Z0  ¼ 0 ð9Þ

where rjt is the nominal return on asset j in excess of the rate of interest of the currency in which returns are measured for j ¼ 1, . . . , m, from time t À 1 to time t; rmt is the excess return on the world market portfolio, and ItÀ1 is the set of information available at time tÀ1. Cov[] is covariance notation. The time-varying coefficients li,tÀ1 , i ¼ 1, . . . , L, are the world prices of exchange rate risk and the time-varying coefficient lm,tÀ1lm,tÀ1 is the world price of market risk.

where Z is a T  l matrix and  is a T  (1 þ m) matrix (T is the number of observations). This represents a total of l  (1 þ m) moment conditions. Under this framework, there are l parameters , and l  ðL þ 1Þ parameters , so there are l  ð1 þ mÞ less l  ðL þ 2Þ overidentifying restrictions. In this study, the above specifications are not followed exactly. Instead, one exchange rate, one domestic equity

2

One exception is for the 90-day commercial paper rates of Taiwan, which is obtained from the Taiwan Economic Journal Data Bank.

Foreign exchange risk, world diversification and Taiwanese ADRs
index, and one world index are chosen for the right-hand side of the international asset pricing model. The returns on the left-hand side are the returns on ADRs. The advantage is that it can be tested if the foreign exchange risk is priced, and if the world market index provides extra information given the domestic equity index in one single equation. The time-varying property of coefficients is still preserved in this model. Specifically, Equation 5 is replaced with the following: ut ¼ ÀZtÀ1  þ ZtÀ1 s rs,t þ ZtÀ1 m rmt þ ZtÀ1 w rwt ð50 Þ

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where ZtÀ1 is the vector of instrumental variables at time tÀ1 as described above, rs,t is the excess return on exchange rate, rmt is the excess return on domestic equity market, rwt is the excess return on world market,  and s are time-invariant vectors of weights. The estimation method is exactly the same as Dumas and Solnik (1995), which uses Hansen’s (1982) general method of moments (GMM) to estimate the parameters. IV. EMPIRICAL RESULTS Table 1 reports the five excess returns of ADRs regressed on the instruments assumed in the model. In this study, it is assumed that the instruments include the following: S&P 500 index, MSCI world index, exchange rate return, 3-month US Treasury rate, and the 90-day Taiwanese commercial paper rate with one lag and Taiwan stock index return. The reason why Taiwan stock index without lag is used is that when the US market is open, the closing price of Taiwan stock index on the same calendar day is known to the US investors. These instruments represent the set of information available to them. Significant coefficients
Table 1. ADR excess returns regressed on instrumental variables ASX Constant SP500_R(À1) TWIND_R MSCI_R(À1) EX_R(À1) TB3M_R(À1) CP2_90R(À1) R2 F-statistic À0.004 (À0.56) 0.1386 (0.48) 1.0324 (12.32)*** À0.7064 (À2.06)** 0.0499 (0.10) À76.1379 (À0.44) 97.1510 (0.45) 21.57% 26.32 MXICY À0.0160 (À1.98)** À0.2418 (À0.89) 1.2115 (15.19)*** À0.5169 (À1.58) À0.1263 (À0.26) À186.1630 (À1.14) 290.2024 (1.09) 29.60% 40.23

are found for Taiwan stock index for all of the five ADRs and significant MSCI for two of the five ADRs at a 5% significance level. The average R2 s is around 23%. The findings suggest that the instruments chosen can explain the variations in ADR returns. The main result of this study is given in Table 2. Each column represents a coefficient vector in Equation 50 . As can be seen, significant coefficients are found for Taiwan stock index return (TWIND_R) at 5% significance level for all the independent variables: exchange rate, S&P 500 index and MSCI index. Also a significant coefficient of the instrument S&P 500 index with one lag (S&P500_R(-1)) are obtained for exchange rate at 5% significance level. The null hypothesis that all the coefficients for exchange rate are zero is rejected at 5% significance level from the Wald test. The null hypothesis that all the coefficients for MSCI are zero is also rejected at 10% significance level. These empirical results indicate that under the assumption that the information set is represented by S&P 500 index, MSCI world index, exchange rate return, 3-month US Treasury rate, the 90-day Taiwanese commercial paper rate all with one lag, and Taiwan equity index without lag, exchange rate risk is priced in Taiwanese ADR returns at 5% significance level, and the world index is priced in Taiwanese ADR returns at 10% significance level. Also it is found that the significant risk premiums of foreign exchange risk and world index risk are mainly affected by the risk of the Taiwanese equity index. S&P 500 index also plays some role in explaining the foreign exchange risk. The null hypothesis that the moment restrictions are valid in the GMM estimation is not rejected at 5% significance level. In this study, there is a total of l  ð1 þ mÞ with l ¼ 7 and m ¼ 5, or 42 moment conditions, and 28

SPIL À0.0024 (À0.29) À0.2443 (À0.88) 1.1656 (14.22)*** À0.2061 (À0.61) 0.1070 (0.21) À46.01 (À0.27) 45.7925 (0.22) 26.37% 34.27

TSM À0.0035 (À0.40) 0.0977 (0.33) 0.9529 (10.92)*** À0.8713 (À2.44)** À0.6766 (À1.26) 41.0600 (0.23) À11.5259 (À0.05) 18.35% 21.50

UMC À0.0049 (À0.56) À0.0809 (À0.27) 1.0117 (11.62)*** À0.6706 (À1.88)* À0.9817 (À1.84)* 0.9535 (0.01) 30.00 (0.13) 20.02% 23.95

Notes: The numbers in parentheses are the t-statistics. *, ** and *** indicate significant at 10%, 5% and 1% significance levels, respectively.

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Table 2. GMM estimation of the conditional international asset pricing model  Constant EX SP500 299.6622 (0.84) À1171.542 (À0.11) À7267.659 (À2.57)** À2357.124 (À0.18) À71045.80 (À1.32) 5722908 (0.92) À7712747 (À0.96) MSCI À293.9000 (À0.75) 1471.392 (0.10) 8854.250 (2.55)** 738.4337 (0.04) 77630.61 (1.27) À4952603 (À0.70) 6889852 (0.77)

A.T. Wang and S.-Y. Yang
results are shown to be mainly affected by the Taiwan equity index. The US equity index is also shown to contribute to the foreign exchange risk premiums. In sum, when international investors purchase ADRs issued by Taiwanese multinationals in the US markets, these ADRs help investors diversify their portfolios globally and compensate investors for the risk-taking of the foreign exchange risk between US dollar and New Taiwan dollar. The market segmentation effect between these two countries is thus reduced.

0.8659 À1671.155 (1.62) (À0.84) SP500_R(À1) 21.2842 À60413.84 (0.70) (À2.00)** TWIND_R À9.4109 10879.23 (À1.17) (2.04)** MSCI_R(À1) À18.3160 61843.01 (À0.63) (1.62) EX_R(À1) 123.1894 À29884.02 (1.06) (À1.36) TB3M_R(À1) 15080.90 À30865180 (1.69)* (À1.23) CP2_90R(À1) À17304.87 41895727 (À1.56) (1.11) Wald test: H0: all column 3 coefficients are zero ChiÀsquare 17.89** p-value 0.0125

REFERENCES
Alexander, G. J., Eun, C. S. and Janakiramanan, S. (1988) International listings and stock returns: some empirical evidence, Journal of Financial and Quantitative Analysis, 23, 135–52. Dumas, B. and Solnik, B. (1995) The world price of foreign exchange risk, Journal of Finance, 50, 445–79. Errunza, V., Hogan, K. and Hung, M.-W. (1999) Can the gains from international diversification be achieved without trading abroad?, Journal of Finance, 54, 2075–107. Foerster, S. R. and Karolyi, G. A. (1999) The effects of market segmentation and investor recognition on asset prices: evidence from foreign stocks listing in the United States, Journal of Finance, 54, 981–1013. Hansen, L. P. (1982) Large sample properties of generalized method of moments estimators, Econometrica, 50, 1029–54. Jorion, P. (1991) The pricing of exchange rate risk in the stock market, Journal of Financial and Quantitative Analysis, 26, 363–76. Kato, K., Linn, S. and Shallheim, J. (1991) Are there arbitrage opportunities in the market for American depository receipts?, Journal of International Financial Markets, Institutions and Money, 1, 73–89. Kim, M., Szakmary A. C. and Mathur, I. (2000) Price transmission dynamics between ADRs and their underlying foreign securities, Journal of Banking and Finance, 24, 1359–82. Rosenthal, Ld. (1983) An empirical test of the efficiency of the ADR market, Journal of Banking and Finance, 7, 17–30. Wahab, Md., Lashgari, Mk. and Cohn, R.(1992) Arbitrage opportunities in the American depository receipts market revisited, Journal of International Financial Markets, Institutions and Money, 2, 97–130.

13.23* 0.0668

Notes: Chi-square: 18.6911; right-tail p-value: 0.1771; degree of freedom: 14. The numbers in parentheses are the t-statistics. *, ** and *** indicate significant at 10%, 5% and 1% significance levels, respectively.

parameters, so there are 14 overidentifying restrictions. The results are reported at the bottom of Table 2. The chisquare statistic is 18.69 with 14 degree of freedom and the p-value is 0.1771.

V . C O N C L US IO N The preliminary results obtained by the two-stage least squares method (not reported in this paper) do not yield significant foreign exchange risk premium. However, when applying the conditional international asset pricing model in which coefficients are represented by linear combinations of instruments, a significant foreign exchange risk is found in Taiwanese ADRs.3 These results suggest significant and time-varying foreign exchange risk premiums as well as world equity index risk premiums. These significant

3

This contradicting result is in line with the observations by Dumas and Solnik (1995): when tested in unconditional forms, the foreign exchange risk is not priced; when tested in conditional forms, that is, the coefficients are time-varying and represented by a vector of instruments and multiplied by a vector of constants, the foreign exchange risk is priced.