Arbitrage and the Law of One Price in the market for American depository receipts

Hamad Alsayed and Frank McGroarty

Journal of International Financial Markets, Institutions and Money, 2012, vol. 22, issue 5, 1258-1276

Abstract: Ours is the first paper to highlight pairs trading as the main price-correcting mechanism by which arbitrage can maintain stock–ADR parity. We show that arbitraging stock–ADR pairs extracts small per-trade profits which accumulate to a substantial aggregate return. The observed strong tendency of pricing disequilibria to mean-revert, along with the two-way convertibility between stocks and ADRs, mean that arbitrageurs face minimal risks toward price divergence. They do, however, face uncertainty about the duration of individual trades. The magnitude of this uncertainty relates directly to the profit target arbitrageurs set after a long/short position is established. This fact can explain why some disequilibria go unexploited. Overall, our work provides evidence against automatically efficient prices, and supports the view that mispricings incentivize arbitrageurs to enforce market efficiency.

Keywords: American depository receipts; ADR; Arbitrage; Law of One Price; Pairs trading (search for similar items in EconPapers)
JEL-codes: F36 G14 G15 (search for similar items in EconPapers)
Date: 2012
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Citations: View citations in EconPapers (16)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:intfin:v:22:y:2012:i:5:p:1258-1276

DOI: 10.1016/j.intfin.2012.07.002

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