The Linkage between the U.S. 'Fear Index' and ADR Premiums Under Non-Frictionless Stock Markets

This paper examines the effects of the U.S. investor sentiment on American depository receipts (ADR) premiums by using daily prices of Latin American ADRs from 1995 to 2009. The volatility index (VIX) is used as a proxy for investor expectations about the stock market. High levels in the VIX indicate that investors are fearful about future performance of the U.S. stock market. We estimate a GARCH-M in the framework of an ADR pricing model. We control for liquidity, transaction costs, and domestic and U.S. stock exchange returns. We find that deviations from the law of one price in ADRs can be partially explained by the lag of the smoothed volatility index. There is a structural break in the sample period before and after the enactment of the Sarbanes-Oxley Act. This paper has important implications for portfolio diversification on emerging economies as investment managers can improve hedging strategies by incorporating known values of the volatility index