Nonlinear interrelations between ADRs and their underlying stocks revisited: application of threshold VECM

This study examines the dynamic interrelations between American depository receipts (ADRs) and their underlying stocks (UNDs) by using the threshold vector error correction model. In contrast to prior studies focusing on examining the effects of arbitrage threshold on stock return means, this study not only analyse the dynamics of return means but also return volatilities. Moreover, this article adopts two representative ADR issuers: UK VOD and Brazil CVDO and compares the differences between them. The empirical findings of this study are consistent with the following notions. First, for both of the case of UK VOD and Brazil CVDO, once the price relationship of ADRs and UNDs deviates away from the long-run cointegrated equilibrium, the re-establishing equilibrium process is more/less remarkable when the price deviations do (do not) exceed a critical threshold. However, for the case of UK VOD (Brazil CVDO), the tendency to adjust to correct a disequilibrium situation mostly depends on the UND (ADR) markets. Furthermore, this article denotes the threshold estimate in the case of UK VOD (Brazil CVDO) as an unusual (extreme) condition. Last, the arbitrage behaviours between the ADR and UND markets will increase the volatility in these two markets and reduce the correlation between them.