In the domestic market, sales by foreign institutional investors (FIIs) have been offset by large purchases by home-grown insurance companies and mutual funds.

But on the New York Stock Exchange (NYSE) and Nasdaq, where ADRs trade, no such counterparts exist for foreign investors. Still, only three of the 11 cross-listed ADRs saw a drop in their premium over the Indian market or witnessed an increase in the discount.

In fact, the premium on the Skindia GDR index (the index includes ADRs as well) has increased from 1.74% at the beginning of the year to 5.98% currently. What gives?

Gautam Chand, chairman and chief executive of Instanex Capital Consultants Pvt. Ltd, says when depository receipts trade at a discount, traders exercise the option of buying the receipts and cancelling them, which essentially results in a conversion into local shares, which the trader can then sell at a higher price. Since this arbitrage is possible, both ADRs and global depository receipts (GDRs) normally don’t trade at discounts.

Also See Depository Receipts Hold Their Own (Graphic)

On the other hand, there is much less flexibility with converting local shares into depository receipts, in part because restrictions on overall foreign holding permitted in a firm and because of what is known as non-availability of headroom. If a company has originally converted “x" number of local shares into depository receipts, that is the maximum permissible float for ADRs/GDRs. Traders can’t convert local shares into receipts unless the existing float is below “x". For most depository receipts, there is little or no headroom available.

Chand, who made a presentation at the recent research meeting on capital flows conducted by the National Institute of Public Finance and Policy and the department of economic affairs, points out that depository receipts now account for a large chunk of trading done by foreign investors. According to data collated by Instanex, 30% of all purchases and sales of Indian securities by foreign investors are done overseas. About three-fourths of this happens in the market for depository receipts, while the balance is accounted for by exchange-traded funds.

It’s interesting to note that a few of the top-traded ADRs are more liquid than their local counterparts. When seen as a percentage of the available floating stock, four of the top five traded ADRs are more liquid than local shares. For instance, nearly 3% of ICICI Bank Ltd’s floating stock on the NYSE, on an average, trades daily. In India, combined turnover on the Bombay Stock Exchange and the National Stock Exchange amounts to a much lower 1.06% of the floating shares. Needless to say, overseas investors are more active in churning their portfolio, compared with the likes of Life Insurance Corp. of India and a large number of long-term retail investors in India.

On the one hand, the high turnover in the ADR market means that its price signals are important. But on the flip side, the constraints on converting local shares into depository receipts hamper price discovery.

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