Volatility links between the home and the host market for U.K. dual-listed stocks on U.S. markets

https://doi.org/10.1016/j.intfin.2014.08.005Get rights and content

Highlights

  • We investigate the transmission of idiosyncratic and systematic risks between U.K. ADRs and their underlying stocks.

  • We defined idiosyncratic and systematic risks as volatility ratios and standardized beta ratios, respectively.

  • We found that stock variation tends to revert to idiosyncratic variation, while stock variation tends to persist to systematic variation.

Abstract

We investigate how idiosyncratic and systematic effects impact the volatility risk of U.K. cross-listed stocks. Under the hypothesis that more stock followers enhance information effects on volatility, we examine whether variation in volatility of a cross-listed stock has in a bivariate setting two edges. We establish a two-dimensional volatility variation of different magnitudes for U.K. cross-listed stocks. Specifically, we find that idiosyncratic effects induce volatility reversal, whereas systematic effects induce volatility continuation. Our findings imply that the volatility risk of a cross-listed stock is an integral of intermarket volatility effects.

Introduction

There is a mounting evidence on Merton (1987)'s view that an efficient capital market is a market, where information flow is not hampered by national trading and investment barriers of any kind. In fact, with the successive information technology breakthroughs and the liberalization of capital markets of the last three decades, investors all over the world can virtually trade risk and return globally without leaving the comfort of their home country. Various investment vehicles are available to investors in today's world to trade at home foreign assets. For instance, an American investor can trade at home international funds, Exchange-Traded Funds (ETFs), and American Depository Receipts (ADRs). In this way, the American investor has the opportunity to reduce the “super” national risk premium.

Although, the demand side of home-traded foreign securities would not have been met if the offer side of these securities was not responding as quickly as possible to a strong and an increasing demand for home-made foreign securities. In fact, there is a strong belief that the offer side of home-made foreign securities is driven by firms’ search for efficient ways to lower cost of capital (Foerster and Karolyi, 1999; Stulz, 1999), to increase liquidity (e.g., Smith and Sofianos, 1996), to improve shareholder protection (e.g., Doidge et al., 2004), and to signal for quality (e.g., Foucault and Fresard, 2012).

An overview of studies on international cross-listing reveals that the motives and valuation effects of cross-listing are complex in information effects. For instance, Foucault and Fresard (2012) found that prices of cross-listed stocks are more informative than prices of non-listed stocks. It follows from their findings that not only cross-listing enhances the precision of private information but also opens the eyes of managers of cross-listed firms on value-enhancing projects. Lang et al. (2003) found that cross-listing increases coverage and forecast accuracy with the result that cross-listing enhances the values of cross-listed stocks. Along this line of thought, Hail and Leuz (2009) found that cross-listing reduces the cost of capital, whereas Patro (2000) found that the beta riskiness of a cross-listed stock is a function of both home-market and global market risks.

While Sarkissian and Schill (2009) found that the gains with cross-listing are not permanent, cross-listing is still associated with better information environments. As such international cross-listing is a channel by which asymmetry effects are mitigated through efficient idiosyncratic and systematic transmission of information across trading places. Karolyi (2006) surveyed different aspects of international cross-listing that would suggest that stock value is transformed with international cross-listing. One such aspect that links managerial effects to information (trading) effects is the relative contribution of each trading place to price discovery. In this regard, Eun and Sabherwal (2003) found that Canadian stocks listed in the U.S. show strong leadership in higher total trading volume, whereas focusing on selected German stocks Grammig et al. (2004) found that price discovery in the U.S. is positively related to the liquidity of U.S. trading. Thus, the total variation of a cross-listed stock is conditional on the proportion of actual trading activity that takes place across competing markets. However, it is not clear from these studies what would have been the part of information when liquidity is not a constraint.

Recognizing that liquidity is a function of volatility and volatility is a function of information, we investigate how stock variation is related to idiosyncratic and systematic variation from either trading place. We conduct this analysis under the understanding that international cross-listing is associated with better information environment (Fernandes and Ferreira, 2008). If cross-listing is associated with both strong private information signals and improvements in trading environments, then both idiosyncratic and systematic variation should be negatively related to stock variation.

Against this background, we develop a transmission factor that is a correlation-weighted of volatility ratios. Our factor is different from Hasbrouck (1995)'s factor in that it is a product of volatility ratios and standardized beta ratios. Since by construction these ratios are greater than 1, our factor captures information events and help quantifying stock variation's sensitivity to idiosyncratic and systematic variation from either trading place. We clearly differ from previous studies focusing on the transmission of the total stock variation along these dimensions. While the combined effect of our factor is similar to the effect of stock total variation, the insight of stock variation through both idiosyncratic and systematic channels provide a better understanding of the pricing structure of an ADR and its underlying asset.

We specifically relate our study to Wang et al. (2002) examining the transmission of volatility between the London Stock Exchange and the Hong Kong Stock Exchange. Wang et al. controlled for systematic effects and found that these effects induce a negative volatility spillovers. However, we differ from Wang et al. in that our transmission factor is systematic in beta variation at either trading place. Our study is also related to Werner and Kleidon (1996) showing that information is efficiently transmitted across the U.S. and the U.K. borders within the two hours overlapping daily trading on the two trading places. Werner and Kleidon reached their conclusion on intraday data. We use daily data, which implies that our results is more about price completeness than price discovery.

Using a sample of 76 U.K. stocks cross-listed in the U.S., our findings can be summarized as follows. First, disentangling variance effects into idiosyncratic and systematic effects is more informative than entangling these effects. The direction and the magnitude of the relationships indicate that both investors and managers learn from the ADR and the underlying stock variation (Foucault and Fresard, 2012). However, we could not establish with high level of confidence that more ADR followers lead to higher transmission of idiosyncratic effects from the host market to the home market.

Second, stock variation reverts to idiosyncratic effects on the day of information. The negative sign suggests a high level of trading integration between the U.K. and the U.S. market (Werner and Kleidon, 1996).

Third, stock variation is positively related to systematic variation on the day of information. This is an indication that the beta of a cross-listed stock is subject to intermarket variation (Patro, 2000, Fernandes and Ferreira, 2008).

Fourth, stock variation reverts to systematic effects on the day after information. The one-day lag aligns to some extent with the findings of Rapach et al. (2013) showing that return shocks arising in the United States are only fully reflected in equity prices outside the United States with a lag.

Finally, both idiosyncratic and systematic transmission tend to be stronger from the U.K. market to the U.S. market at the stock level. This may suggest that financial analyst coverage and forecast upon the U.K. ADRs have less impact on stock variation at home than do the combination of insider and private information associated with the underlying stocks on stock variation abroad.

The rest of the paper is organized as follows. Section 2 develops a transmission factor between the home and the host trading place. Section 3 reports our empirical findings. Section 4 concludes the paper.

Section snippets

Empirical models

This section develops a transmission factor across trading places for a cross-listed stock. The factor captures the part of volatility and risk that spill over from one trading place to another.

Empirical results

In this section, we describe the data and report the estimates of the empirical models presented in the previous section.

Concluding remarks

We investigated the information flow between the U.K. and the U.S. market by developing a transmission factor that is a combination of volatility ratios and standardized beta ratios. Our factor is able to separate idiosyncratic and systematic effects from total variation effects. Our findings support the decomposition as stock variation is differently related to idiosyncratic and systematic effects. In general, we found that stock variation at either market is negatively related to

Acknowledgement

We are grateful to the referees for helpful comments and suggestions.

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