Three essays in international finance
Chapter one examines empirically the price discrepancy of Depositary Receipts (DRs) and underlying stocks issued by thirty-five Taiwanese companies under foreign ownership restriction. Large daily premiums in DRs are observed for most companies, and large long-run persistent premiums are observed for three companies. Although market segmentation between Taiwan and world markets is concluded, foreign ownership restriction, under the “Qualified Foreign Institutional Investors” (QFII) program implemented by the Taiwanese government, is not the cause of this segmentation. Nonetheless, foreign demand reflected in QFII is positively correlated with the premiums in DRs, and information flows slowly between the DR and the Taiwan markets.
Chapter two investigates the profitability of arbitrage between six high premium Taiwanese depositary receipts and their underlying stocks. The arbitrage is based on the property of the price premium, which is assumed to be mean reverting around a reference level. Moving average is used to estimate the reference level for “flat shares”, “flat proceeds” and “optimal hedge” strategies. The portfolios under these strategies generate significant returns, outperforming Sharpe ratios, and low correlation with the market in both in-sample and out-of-sample data. This shows the existence of arbitrage under frictionless assumptions. With the inclusion of large bid-ask spreads in the DRs, the profitability is eliminated. Relative thresholds around the reference level are also tested, and some portfolios are able to overcome the large bid-ask spread costs and generate significant positive returns. Although these portfolios are profitable, the returns are very volatile, and the results may not be reproducible.
Chapter three investigates the feasibility of arbitrage in high premium American Depositary Receipts (ADRs) from Taiwan under Taiwanese and U.S. investment regulations. In the security conversion arbitrage, the difficulty lies in the Taiwan government regulations, which prohibit foreign investors from converting large amounts of stock in Taiwan into ADRs in the United States for the purpose of arbitraging the high premium. In the mean-reversion trading arbitrage, the difficulty lies in the prohibition against short selling Taiwanese stocks imposed by the Taiwanese government. Sophisticated traders are able to avoid this regulation by borrowing from another foreign institution.