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Developing and
Implementing
Risk Management
Systems

Fortis Group
Case Study



American Depository
Receipts in The
Global Equity Model



Analyzing the
Performance of
Crossing Networks
The Market
Impact Model™ — Part 4



The BARRA Brainteaser
 for Fall 1998
Solution to the Summer
1998 Brainteaser

American Depository Receipts in The Global Equity Model

by Jason Lejonvarn

As investors seek to diversify their equity holdings, many turn to the popular option of American Depository Receipts (ADRs).¹ Sponsored ADRs list on a U.S. exchange, quote and trade in U.S. dollars, convert their dividends to U.S. dollars, and offer exposure to non-U.S. assets. Underscoring the popularity of ADRs, The Bank of New York—a common ADR issuer—states "the number of Depository Receipt Programs has grown from 109 programs in 1988 to an estimated 1577 programs this year. During the same period, dollar trade volume of U.S. exchange-listed ADRs increased from $41 billion to $503 billion, an increase of 1,127 percent in 11 years."

As of October, BARRA will model ADRs in both the Morgan Stanley (MS) and the Financial Times (FT) versions of its Global Equity Model (GEM). The Aegis System™ will now recognize an ADR identifier such as a cusip. Initially BARRA will add 442 ADR assets to the GEM database. As clients provide important feedback, BARRA will continue to expand its coverage of ADRs and will eventually add coverage of Global Depository Receipts (GDRs).

Modeling ADRs in GEM

As indicated by the BARRA permanent identifier, each ADR is mapped to the underlying asset. The capitalization and risk characteristics are also mapped directly to the ADR from the underlying asset. The returns of an ADR may be slightly less than the return of its underlying asset due to a small market cost for an ADR, a legal constraint placed on an ADR, or an arbitrage opportunity.

This one-to-one map of the risk characteristics from the underlying asset onto the ADR should not surprise investors. They buy ADRs to gain exposure to a country and currency outside the United States. In support of this direct mapping, FIGURE 1 compares the annualized volatility of returns of the ADR, sr_(ADR) , to the annualized volatility of returns of the underlying asset in GEM, sr_(GEM). The correlation of the two variables, r_{(ADR, GEM)}, for some of the most popular ADR assets is nearly one. The simple mean of the correlation for 367 of the ADRs is 0.94 while the cap-weighted mean is slightly higher at 0.95.²

FIGURE 1: A comparison of annualized volatility between an ADR and its underlying asset

How to screen on ADRs

Aegis Suite clients will enjoy access to a portfolio of all the ADRs covered as well as a portfolio of underlying assets, named adr.por and under.por respectively. Additionally, a file named adryymm.prn will be delivered with each monthly GEM update. Clients can process this file as custom data and then add the variable, adr_flag, to their workspace. This variable permits a clear distinction between an ADR and its underlying asset. This distinction is important since the specific risk of an ADR and its underlying asset are not linked. If investors hold both an ADR and its underlying asset in the same portfolio, then a small amount of specific risk will exist between the two assets. Aegis Suite 3.0 will link that specific risk.

The Aegis Risk Manager demonstrates the utility of the adr_flag variable. (See FIGURE 2.)

FIGURE 2: Variable, adr_flag, in the Aegis Risk Manager Workspace

Optimization with ADRs

Clients can use the ADR portfolio adr.por to track international indices, thereby avoiding time delays in exiting international markets and excessive local brokerage costs. For example, a client who would like to mimic the Morgan Stanley Capital International benchmark, MSEAFE, can purchase 50 names and attain a tracking error of less than 3%.

The Aegis Risk Manager shows the total active risk, 2.67%, of the optimized portfolio. (See FIGURE 3.)

FIGURE 3: Risk decomposition view from the Aegis Risk Manager

A client could construct a similar portfolio with the purchase of 150 names of the 442 ADRs provided in GEM, and track the MSEAFE with risk of 1.96%.

BARRA welcomes the comments and suggestions of its clients as it continues to improve and build new global equity analytics.

¹ Receipts traded on a U.S. exchange are sometimes called Global Deposity Receipts (GDRs). This article uses the traditional definition of an American Depository Receipt—a depository receipt held by a U.S. trustee and often traded on a U.S. exchange. 

² Some of the 442 ADRs were dropped due to a lack of data.