Explaining Premiums in Restricted DR Markets and Their Implication

8/9/2019 Explaining Premiums in Restricted DR Markets and Their Implication

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Explaining Premiums in Restricted DR Markets and Their Implications: The Case of Infosys

Author(s): John PuthenpurackalSource: Financial Management, Vol. 35, No. 2 (Summer, 2006), pp. 93-116Published by: Blackwell Publishing on behalf of the Financial Management AssociationInternationalStable URL: http://www.jstor.org/stable/30129853

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Explaining Premiums i n RestrictedD R M a r k e t s a n d T h e i r Implications:

T h e C a s e o f I n f o s y sJohn Puthenpurackal*I examine severalpossible explanationsfor whyInfosys' Depositary Receipts (DRs) trade atsignificant premiums to the equivalent underlying domestic shares. I find that a limitedsupply ofDRs and a downward-slopingdemandcurve,significant transaction costs associatedwith investing directly in the domestic market,and trend-chasing bysmaller andpotentiallyuninformedinvestorspartly explain the DR premiums. I also examine the wealth effects ofnon-capital raising secondary depositary receipt offerings by Infosys Technologiesandfindsignificant wealth transfersfrom existing DR holders to selling domestic shareholders whoare comprised significantly of lnfosys 'founders.

Internationalcapitalflows increaseddramatically n the 1990s as financial markets around heworld liberalized and investors pursued the benefits of international diversification andpotentially higher returns.Several innovative financial instrumentswere created in response toinvestor demand forproductsthatprovidedinternationaldiversification. One of the mostpopularinstruments continues to be depositary receipts (DRs). DRs are the cross listing of a bundle ofdomestic sharesof a foreign companyin the US (calledAmericanDepositary Receipts, ADRs) orin a non-US market ike LondonorLuxembourg(called GlobalDepositary Receipts, GDRs).In the absence of barriersto arbitragebetween the DR market and the underlying domesticsharemarket,DRs should tradewithin transaction cost bands of the currency-adjustedprice ofequivalentdomestic shares. Supportingthis reasoning, GagnonandKarolyi (2004) find that thecurrency-adjustedprices of most cross-listed shares and their equivalent home-market shareslie within a 20 to 85 basis point band of each other.One of the major exceptions to this finding are the significant DR premiumsfor a number ofIndian firms. Barriers to arbitragecan result in the segmentation of the DR and underlyingdomestic market, thus allowing securities with identical cash flows and voting rights to bepriced differently in each market.In this article I examine the exact natureof the segmentationof the DR andunderlyingdomesticsharemarket for Indian stocks. I study the institutional marketfrictions, such as restrictions onDR-underlyingdomestic shareconvertibility, hat constrainarbitrageand thus allow the existenceof large DR premiums.Otherpapersexamine how investment restrictions and market frictionscan induce segmentationin othercontexts, but to my knowledge, my article is the first to look athow segmentation can arise between the DR and underlyingdomestic sharemarket.''Bailey and Jagtiani (1994), Stulz and Wasserfallen (1995), Loderer and Jacobs (1995), Bailey, Chung, and Kang(1999), Domowitz, Glen, and Madhavan (1997), and Sun and Tong (2000).I especially hankan anonymousefereeor helpful uggestionshatsignificantlymprovedhequalityof thepaperDanielDorn,JeanHelwege,RodolfoMartell FMAdiscussant), ariusMillerIngridWernereminar articipants tOhio University,Ohio StateUniversity nd the FinancialManagement ssociationMeetings n New Orleans,andespeciallyAndrewKarolyialso offeredhelpfulcomments. ridharGogineni,GautamKapur,Venkat rovi,JingLiu,Deepa Raghavan nd SiddarthRanganprovidedexcellentresearchassistance.Theauthoracknowledgesinancialsupport romthe Gardner ellowship t OhioUniversity'JohnPuthenpurackals an AssistantProfessorn Financeat University f Nevada,Las Vegasn Las Vegas,NVFinancial Management * Summer 2006 * pages 93 - 116


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94 FinancialManagement Summer2006Although arbitragerestrictions between the DR market and underlying domestic sharemarketmay allow DRs to trade at significant premiums,it does notexplain why DR investorsarewilling to pay a higher price than are domestic investors for a securitywith the same cashflow andvoting rights. Given that the limit on foreign ownershipof domestic shares has notbeen reachedforInfosys Technologies,which is the IndianDRtradingat the highest premium,

I wish to determinewhy foreigninvestorspurchase he DR insteadof the underlyingdomesticshares. I examine several potential explanations for why Infosys depositary receipts trade atsignificant premiums to the equivalent underlying domestic shares.I find evidence to suggest that a limited supply of DRs and a downward-slopingdemandcurve, significanttransactionscosts associated with investing directlyin the domestic market,andtrend-chasingby smaller andpotentiallyuninformed nvestorspartly explainthe existenceof the DR premiums.When there are significantDR premiums, largedomestic shareholdershave an incentive tolower their ownership stakes by selling additional DRs periodically through secondaryDRofferings, since doing so allows them to capturesome of the premium.Inwhatappears o be aresponse to this incentive, Infosys undertook two non-capital-raising secondary depositaryreceiptissuancesinJuly2003 andMay2005 in whichthecompanyconvertedexistingdomesticshares, selected througha tenderoffer, into DRs for sale through secondaryDR offerings. Ifind that the gains obtained by selling domestic shareholders through the secondary DRofferingscome at theexpenseof existingDRholders.Ialso find that argedomesticshareholders,such as the firm's founders,benefit the most fromthe secondaryDR offerings.I also use Infosys Technologies' secondaryDR offering to highlight a particularbenefit ofa US cross-listing, namely, thatit allows large domestic shareholders,such as firm founders,to profitably diversify their ownership stakes. Doidge, Karolyi, and Stulz (2004) find thatforeign firms that are cross-listed in the US have higher valuations than those that are not.A US cross-listing can widen the investor base (see Foerster andKarolyi, 1999), and can alsoincrease liquidity in both the DRs and underlying domestic shares, due to the improvedinformation environment associated with a cross-listed stock (see Smith and Sofianos, 1997;Langet al., 2003, 2004). Hence, aUS cross-listing is particularlybeneficial for largedomesticshareholders,such as founders of firmsthatoperatein segmentedor less-developed financialmarkets who wish to diversify their ownership stakes.To better understand he motivations of its US cross-listing, I analyze time-series changesin ownership of both Infosys domestic shares andInfosys DRs. I find that a US cross-listingattracts new investors, with foreign institutional investors taking sizeable stakes in bothdomestic shares and DRs. Further,if large domestic shareholders choose to divest theirownership stakes at more favorable prices, this deepening of the investor base is likely tofacilitate such a move. Supporting his hypothesis, I find thattwo largedomestic shareholdersof Infosys significantly reduce their holdings after the cross-listing. In addition, duringInfosys' secondaryDR offering, large domestic shareholders, ncluding firm founders,wereable to reduce theirholdings moreprofitably throughthe DR marketdue to the DR premium.The article is organized as follows. Section I provides statistics on DR premiums for asampleof firms from differentcountries,andhighlightbarriers o arbitrage hat can allow DRpremiums to exist. Section II explores possible explanations for the existence of Infosys'significant DR premium. Section III shows how large domestic shareholders, such as firmfounders, exploit the existence of the DR premiumto profitably lower their stakes throughsecondary DR offerings. Section IV highlights the benefit of a US cross-listing to largedomestic shareholders fromcountries with segmented andless-developed financialmarkets.Section V concludes.


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PuthenpurackalExplainingremiumsnRestrictedRMarketsndTheirmplications 95I. Priceof DRs Relative to EquivalentUnderlyingDomestic SharesSince depositary receipts (DRs) are the cross listing of a bundle of domestic shares of aforeign company, I expect that the prices of DRs and the equivalent underlying domesticshares will remain within arbitragetransaction costs if there are no restrictions on flows

between the DR marketand the underlyingdomestic share market.TableIprovides statisticson the DR premiumscollected fromBloomberg for firms fromselected countries.The statistics show that DRs for several firms from India and Taiwan Semiconductor tradeat significant premiumsto the equivalent underlying shares. On the other hand, the DRs offirms fromcountrieslike Finland,Japan,andUK, which do nothave restrictionson the flowsbetween the DR market and underlyingdomestic sharemarket,trade close to the currency-adjusted price of equivalent underlying shares (see Miller and Morey, 1996). Accordingly,DR programsare classified based on the degree of restrictiveness of flows between the DRmarketand the foreignmarket.In a two-way DR programsuch as those in countries like Finland,Japan,andUK, there isan unrestricted flow between the DR marketand the underlying domestic sharemarket,sothe prices of DRs and the equivalent underlying domestic shares remain within transactioncosts due to arbitrage.In a limited two-wayDR program, henumberof DRs is limitedby thenumberof DRs fromthe initial DR offering. Hence, firms can cancel and reissue DRs, but only up to the initialoffering size. Limited two-way programs are typically those by Korean, Taiwanese, andIndianfirms.

Finally, hereareone-wayprograms,which arethemostrestrictive.Over ime,firmsmaycancelDRs, but subsequentreissuance is not permitted.I note that some countries such as IndiastartedheirDRprograms sone-way programs nd aterconverted o limitedtwo-way programs.For restricted DR programssuch as limited two-way andone-way programs,the prices ofDRs and the equivalent underlying shares can diverge significantly. Arbitrageactivities areconstraineddue to restrictionson new issuance of DRs, and hence will not necessarily alignprices. For example, an Indian shareholderin Infosys Technologies cannot convert and sellhis domestic sharesas DRs in the US marketeven ifDRs aretradingat a significant premiumbecause of the restrictions on new DR issuance. Therefore,premiumsfor DRs can persist inrestricted DR markets. On the other hand, discounts on DRs, which are greaterthan thoseallowed by transactioncosts, should not exist, since DR holders can convert their DRs intounderlying domestic shares and sell them in the domestic market. Thus, DR-underlyingdomestic-shareconvertibilityrestrictionscan induce marketsegmentation, in thatprices for

identical claims to cash flows and voting rights can vary significantly across markets.A. InvestmentlArbitrage Restrictions in India

Most of the DRs that tradeatpremiumsarethose issued by Indianfirms. Therefore,in thisarticle I focus on Indian firms and in particular,Infosys Technologies, to shed light on thedeterminants f DRpremiums.As noted,IndianDRs were initiallyissued as one-way programsbut were converted to limited two-way programs in February2002. Thus, investors canconvert existing shares into DRs only if some DRs from the initial issuance have beenconvertedback into domestic shares. So, if DRs outstandingareequal to the number of DRsoriginally issued, investors cannot convert domestic shares into new DRs. The only entitythat can issue new DRs is the issuing firm,which musthave the approvalof the government.Hence, the number of DRs available is limited by the DRs actually issued by the company,


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96 FinancialManagement Summer2006Table I.Statistics on DRPremiums and Determinants of DRPremiumsThis tableprovides ummarytatistics n DR premiumsor 21 activelyraded ndian ompaniesnd 8companiesrom ountriesutside ndia. computehe statisticssingmonthly Rpremiumsortheperiod1/31/1997o 5/31/2004 ollectedromBloomberg.henumberf observationsoreachDRvaries,ince hecompaniesross-listtdifferentointsn time.A indicates DRsandG ndicates DRs.

DRPremiums(%)Issuer Std Dev Mean 25th Median 75th NBajajAuto (G) 15.62 13.60 1.06 10.02 24.27 89Dr.Reddy'sA) 16.73 -5.79 -3.18 0.46 2.07 38HDFCBank A) 9.46 11.05 4.13 8.87 19.19 35HindalcoG) 10.20 8.30 0.95 5.95 14.46 89GailIndiaLimitedG) 5.09 -1.02 -3.98 -1.35 1.79 55Gujarat mbujaCementG) 8.43 2.50 -2.23 0.22 5.46 89Grasim ndustriesG) 17.60 13.22 1.06 8.06 21.29 89Mahindra MahindraG) 10.37 4.03 -2.40 0.00 10.77 89RelianceEnergyG) 10.46 8.48 0.03 6.34 14.83 89TataMotorsG) 9.19 4.47 -1.05 1.54 10.21 89ICICIbank(A) 15.14 15.99 5.48 12.09 23.99 51Infosys Technologies (A) 37.96 63.69 44.16 54.38 71.07 63ITC(G) 11.94 13.59 4.82 10.24 20.28 89Larsen& Toubro G) 9.98 4.94 -1.45 1.70 9.45 88MTNL(A) 14.98 12.69 0.44 8.26 24.31 66RanbaxyLabs(G) 19.13 17.35 6.56 12.12 22.86 89Reliance Industries G) 17.07 11.01 0.72 5.84 14.91 89SatyamComputers A) 18.27 21.53 11.06 14.60 21.82 37State Bank of India(G) 15.11 19.51 9.16 18.21 27.15 89VSNL (A) 15.91 -4.03 -2.63 -1.23 2.08 46WiproA) 11.70 8.87 -0.14 5.81 14.11 44Taiwan Semiconductor A) 20.92 35.55 16.95 35.80 50.25 80CableandWirelessA) 2.03 0.68 -0.59 0.49 2.08 89DeutscheTelekomA) 1.68 -0.37 -0.97 -0.34 0.45 89Nokia A) 2.11 -0.43 -1.75 -0.49 0.61 89NipponTelegraphndTelecomA) 1.95 0.50 -0.61 0.47 1.14 89SonyCorporationA) 1.92 0.38 -0.69 0.38 1.44 87ToyotaMotorsA) 1.25 0.47 -0.23 0.32 0.99 89

and this number cannot be increased by depositary banks to meet DR investor demand.Non-Indian investors can own shares of cross-listed Indian firms either throughDRs orthe underlying domestic shares. The government of India has imposed limits on foreignownership of Indian firms. These limits vary fromindustryto industry.Typically, there is anautomatically approved foreign ownership limit (less than 50%), which is lower than theforeign ownership industry limit imposed by the government. Shareholders of individualfirms can choose to relax this automatically approved limit, up to the foreign ownershipindustry limit. Hence, shareholders have control on how much of the firm's equity can bebought by foreign investors beyond thatautomatically approved imit. From2001 onwards,the limit on foreign ownership in IT companies such as Infosys Technologies is 100%,andno single foreign investor may hold more than 10% of a company's total equity shares. InJuly 2002, Infosys shareholderspassed a resolution that allows 100%foreign ownership ofInfosys Technologies.


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PuthenpurackalExplainingremiumsnRestricted RMarketsndTheirmplications 97B. DirectEvidence on Flows Between the DRand UnderlyingDomesticShare MarketTopresentdirect evidence on the flows between the DR marketand theunderlyingdomesticshare market that allow arbitrage o occur, I obtainproprietarydata from a majordepositary

bank that provides information on monthly DR outstanding information for InfosysTechnologies (a limitedtwo-way program)and two DR programsthat have no convertibilityrestrictions(two-way programs).Table II shows that because of the restrictionsthatprevent arbitrage,the numberof DRsoutstanding for Infosys' DR programis relatively stable over time. No cancellations takeplace, since Infosys DR holders get better prices in the DR market, hence, they will notcancel their DRs to sell in the home market.The only times that the numberof DRs changearewhen new DRs are issued underemployee stock option plans (ESOPs) or when Infosysmakes a secondaryDR issue, as it did in July 2003.Table II also shows that the number of outstandingDRs changes over time for two-wayDR programslike Deutsche Telekom and Petroleum Geo-Services. These changes aredue toarbitrageactivities and the consequent issuance and cancellation of DRs, which keeps DRprices within transactions cost of the currency adjusted price of equivalent domestic shares.

II.Potential Reasons WhySome Restricted DRs Tradeat Premiumsto TheirUnderlyingSharesAlthough arbitragerestrictions between the DR market and underlying domestic sharemarketmay allow DRs to tradeat significant premiums,it does not explain why DR investors

arewilling to pay a higher price thanaredomestic investors for a securitywith the same cashflow andvoting rights. Given that the limit on foreign ownership of domestic shareshas notbeen reached for Indian DRs such as Infosys Technologies, DR investors have the option topurchasethe underlyingdomestic shares instead of the DRs. Here, I explore and test somepotential explanationsfor why US investors might be willing to pay premiumsfor DRs.A. Lower Cost of Capital

A common reasonwhy DR issuance benefits the issuing firm is that foreign (US and otherdeveloped country) investors are more diversified, and therefore would be willing to accepta lower rate of return han would domestic share investors. Thus, DR issuance is expected tolower the cost of capital for firms, especially those from countries with less-developedfinancial markets.Hence, in completely segmented markets,one would expect DRs to tradeat higher prices than the equivalent underlying shares. However, the DR and underlyingdomestic share marketare not completely segmented,since foreign(US) investors can transactin both the DRs and domestic shares of Infosys. Therefore,a lower acceptablerateof returnby foreign (US) investors does not explain why they pay premiums for DRs instead ofbuying the underlying domestic shares.B. LowerTransactionCosts

PerhapsDR investorsarewilling to pay a higher price for the convenience of tradingin theUS market o avoiddealingwith cumbersomeregulatoryprocedures orforeign(US) investors,foreign exchange conversion, identifying reliablebrokers, custodial, and back-office service


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98 FinancialManagement Summer2006TableII.Changes in DROutstandingFor a Few DRPrograms

Thistablepresentshewayin whichDRsoutstandingor 3 DRprograms,eutscheTelekom, etroleumGeo-Servicesnd nfosysTechnologies,hange n amonthlyasis.The ablealsoreportsmonthlyssuanceandcancellationf DRs.DRO/SrepresentsRoutstanding.obtainhedata rom depositaryank.Deutsche Telekom AG - DR

Date Issued Cancelled Net Change DRO/SJul-02 131,534 3,856,569 -3,725,035 177,711,563Aug-02 11,061,300 12,513,700 -1,452,400 176,259,163Sep-02 105,016 793,961 -688,945 175,570,218Oct-02 79,095 2,475,920 -2,396,825 173,173,393Nov-02 26,828 2,545,030 -2,518,202 170,655,191Dec-02 488,173 7,120,540 -6,632,367 164,022,824Jan-03 22,375 1,057,375 -1,035,000 162,987,824Feb-03 10 3,172,350 -3,172,340 159,815,484Mar-03 40,200 306,400 -266,200 159,553,284Apr-03 88,735 360,991 -272,256 159,277,028May-03 2,195,572 1,306,573 888,999 160,166,027Jun-03 47,998 768,800 -720,802 159,445,225

Petroleum Geo-Services AS - DRDate Issued Cancelled NetChange DROISJul-02 588,405 212,200 376,205 57,570,111Aug-02 108,200 7,465,393 -7,357,193 50,212,918Sep-02 1,000 788,000 -787,000 49,425,918Oct-02 50,000 3,432,200 -3,382,200 46,043,718Nov-02 1,379,900 0 1,379,900 47,423,618Dec-02 1,597,000 3,000 1,594,000 49,017,618Jan-03 868,400 30,000 838,400 49,856,018Feb-03 327,600 0 327,600 50,183,618Mar-03 1,372,900 100,000 1,272,900 51,456,518Apr-03 0 220,000 -220,000 51,236,518May-03 0 750,000 -750,000 50,486,518Jun-03 250,500 3,588,063 -3,337,563 47,148,955providersin the underlyingdomestic sharemarket,as well aspotentialsettlement anddeliveryproblems when investing directly in the domestic markets of the DR firms. The Indiangovernment requiresthat foreign institutional investors (FIIs) who wish to become eligibleto tradedirectly in Indian securities markets adhere to certainregulatoryprocedures.Theseproceduresinclude registration (the fee for a five-year period is $10,000) with the SecuritiesExchange Board of India (SEBI) and the Reserve Bank of India (RBI), as well as detailedbackgroundinformation about the FII.2Foreign investors can also open sub-accounts witha registeredFIIfor a registration ee of $1000 for a five-year period.Thereare no repatriationrestrictions. Both the initial capital broughtin by the FII and their sub-account holders andthe earnings on the capital can be repatriatedback to their home country.2SEBI ndRBI in Indiaaretheequivalentf the SECandFederalReserveBoard n the US.


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PuthenpurackalExplainingremiumsnRestrictedRMarketsndTheirmplications 99Table II.Changes in DROutstanding For a Few DRPrograms (Continued)

Infosys Technologies - DRDate Issued Cancelled Net change DRO/SMar-00 23,800 0 23,800 4163800Apr-00 634 0 634 4164434May-00 0 0 0 4164434Jun-00 700 0 700 4165134Jul-00 0 0 0 4165134Aug-00 0 0 0 4165134Sep-00 0 0 0 4165134Oct-00 0 0 0 4165134Nov-00 1120 0 1120 4166254Dec-00 280 0 280 4166534Jan-01 2000 0 2000 4168534Feb-01 500 0 500 4169034Mar-01 7200 0 7200 4176234Apr-01 0 0 0 4176234May-01 3200 0 3200 4179434Jun-01 2000 0 2000 4181434Jul-01 0 0 0 4181434Aug-01 0 0 0 4181434Sep-01 0 0 0 4181434Oct-01 9600 0 9600 4191034Nov-01 0 0 0 4191034Dec-01 7400 0 7400 4198434Jan-02 4566 0 4566 4203000Feb-02 0 0 0 4203000Mar-02 29200 0 29200 4232200Apr-02 4800 0 4800 4237000May-02 0 0 0 4237000Jun-02 0 0 0 4237000Jul-02 0 0 0 4237000Aug-02 33300 0 33300 4270300Sep-02 0 0 0 4270300Oct-02 17794 0 17794 4288094Nov-02 8474 0 8474 4296568Dec-02 8790 0 8790 4305358Jan-03 616 0 616 4305974Feb-03 358 0 358 4306332Mar-03 15408 0 15408 4321740Apr-03 0 0 0 4321740May-03 0 0 0 4321740Jun-03 0 0 0 4321740Jul-03 12516 0 12516 4334256Aug-03 6003380 0 6003380 10337636

These costs of transacting n the Indiandomestic marketmay explain to some extent whysome DRs can trade at large premiums. Given these transaction costs, smaller investorswhose transactionsizes are of, say, less than 500 DRs may find paying a DR premiummorecost effective than purchasing directly in the domestic share market,while large investorsmay find purchasing directly in the domestic share market more cost effective.To explore this hypothesis further,I gather foreign investor ownership data on Infosys


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100 FinancialManagementSummer 006Technologies' domestic shares and DRs fromhome market annualreportsand 20-F reports.I present these data in TableIII, Panel A.The table shows that the average number of shares held by a DR investor is around 200.The average number of shares held by a foreign institutional investor (FII) who investsdirectly in the underlying domestic shares is around 80,000 shares. I also find that thepercentage of monthly tradingvolume in Infosys DRs that results from trades of less than400 shares is around40%,since its cross-listing.3This findingsuggests that smaller investorstrade DRs despite the DR premiums, because of their high per-sharetransaction costs ofinvesting directly in the Indian market.Largerinvestors trade the domestic shares directly,since theirper-share ransactioncosts are low. However,I do find some institutional investorswho hold large positions in DRs, and for these investors, high transaction costs areunlikelyto be the reason they hold DRs.Institutional investors with lower transaction costs in the underlying domestic marketcannotexploitthe DR premiumwithoutbearingrisk.Toexploitthepremium,a US institutionalinvestor might decide to maintain an open position in, for example, short DRs and longdomestic underlying shares. This strategywill make money if the DR premiumreduces andmoves to zero over time. However,this strategyis not risk free. Small US investors withhightransaction costs in the Indian marketmay continue to be willing to pay premiums for DRs.Also, De Long, Shleifer, Summers,and Waldmann 1990) arguethat noise traders can causethe premiums to increase for an indefinite period, making this a losing strategy over theshort, and perhaps even the medium, term. Hence, rational investors may not want to usethis strategy.Overall, lower transactioncosts appear o be only partof the explanationof DRpremiums,since DR premiumshave considerable variation over time.1. Higher Liquidity of DRs

Amihud and Mendelson (1986) suggest that relatively illiquid stocks are priced lower tocompensate investors for increased direct transactioncosts, such as commissions and bid-ask spreads.Hence, if DRs are more liquid and have lower bid-askspreadsandcommissions,lower direct transactions costs might also have a bearingon the DR premium.To explore whether these factors explain higher DR prices, I compare monthly tradingvolume and trading turnover of Infosys' DRs and domestic shares, which I obtain fromDatastream.I define monthly trading urnover or shares(DRs) as the monthly tradingvolumein shares (DRs) divided by the number of outstandingshares (DRs).TableIII,PanelB, shows thatmonthly tradingvolume is significantly higherin the domesticmarket,butmonthlytradingturnover s significantly higherin the DR market.Higher tradingvolume in the domestic market is not surprising, since until the first secondary DR issue,only about 3% of the Infosys shares traded in the form of DRs. (After the secondary DRissue in July 2003, about 8%of Infosys' equity traded as DRs.) Higher tradingturnover forDRs indicates shorterholding periodsby DR investors andmay indicate speculative trading.Overall, it appearsunlikely thathigher liquidity in the DR marketexplains the DR premiums.C. The Downward-Sloping Demand Curve

There has been considerable evidence that financial securities have downward-slopingdemandcurves (e.g., Harris andGurrel, 1986; and Stulz andWasserfallen,1995). In the caseof Infosys, the DR andunderlyingshare market s in effect segmented.Withriskless arbitragenot possible, the two markets appearto price independently. Since the number of DRs is3I obtain this data from the NYSE's TAQ database.


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PuthenpurackalExplaining remiumsn RestrictedDR Markets ndTheir mplications 101

TableIII.Ownership

ofInfosys

Shares

byDRHolders

andForeign

Institutional

Investors

OverTime,andLiquidity

Measures

of

Infosys'

Domestic

Shares

andDRs

PanelAshowshowtheaverage

shareownership

ofDRholdersandforeigninstitutional

investors

(FIIs)changesovertime.Thetablealsoprovidesthenumber

ofDR

holders,

domestic

shareholders,

andFIIswiththeirrespective

shareholding.

Iollect

thedatafromhomemarketannual

reportsand20-Freports.

Thetablealsogives

thepercentage

oftotalsharesoutstanding

intheformofDRsovertheperiodMarch1999toMarch2004.PanelBpresents

monthly

trading

volume

andmonthly

tradingturnover

collected

fromDatastream

forInfosys

domestic

sharesandDRsovertheperiodMarch1999toMarch2004.I efinemonthly

trading

turnover

for

domestic

shares(DRs)asthemonthly

tradingvolume

inshares(DRs)divided

bythenumber

ofoutstanding

shares(DRs).Results

ofdifference

inmeans

(t-test)and

medians

(Wilcoxon

signranktest)arealsopresented.

PanelA.Average

ShareOwnership

ofDRHolders

andForeign

Institutional

Investors

(FIIs)OverTime

Mar-99

Mar-00

Mar-01

Mar-02

Mar-03

Mar-04

%TotalSharesintheformofDRs

3.13%

3.15%

3.16%

3.20%

3.26%

7.94%

#fSharesasDRs

1,035,000

2,081,900

2,088,117

2,116,100

2,160,870

5,290,305

#fDRHolders

2,700

13,500

10,100

10,325

11,673

25,375

Average

#fsharesperDRholder

383.33

154.21

206.74

204.95

185.12

208.48

#fDomestic

Shares

32,034,400

64,068,800

64,070,000

64,070,030

64,082,208

61,350,751

#ofDomestic

Holders

9,526

46,313

89,642

88,649

77,009

66,944

Average

#ofsharesperDomestic

holder

3362.84

1383.39

714.73

722.74

832.14

916.45

#fDomestic

sharesheldbyForeign

Institutional

Investors

(FIIs)

8,196,512

16,127,027

19,114,466

24,215,093

25,952,155

27,872,439

#fFIIs

142

270

383

363

354

346

Average

#fdomestic

sharesperFII

57,721.92

59,729.73

49,907.22

66,708.25

73,311.17

80,556.18

TotalOutstanding

Shares

33,069,400

66,150,700

66,158,117

66,186,130

66,243,078

66,641,056

PanelB.Monthly

Trading

VolumeandTrading

Turnover

oflnfosys'

Domestic

SharesandDRs

Domestic

Share

DR

TestofDifferences

Trading

Volume

(indomestic

shares)

11,000,000

1,615,910

***(means)

(11,600,000)

(1,292,550)

***(medians)

Trading

Turnover

0.175

1.209

***(means)

(0.182)

(1.093)

***(medians)

***Significant

atthe0.01level.


11/25

102 FinancialManagement Summer2006limited, investors with the highest reservation prices (e.g., investors who face the highesttransaction costs in the home market, noise traders, or institutional investors with short-termoutlooks)will set theDRprice,which in theInfosyscase is at apremium o theunderlyingshares. If the supply of DRs were suddenly increased by Infosys through a secondaryDRoffer, the price of DRs would fall if the DR demandcurve were downwardsloping. Hence,examining the price reactionof DRs to the announcement of a secondaryDR issue is a cleantest of whether the DR premiumis being drivenpartly by limited DR supply and downward-sloping demand curves in the DR market.Figure 1presentsa chartof DR prices, underlyingdomestic shareprices, and DR premiumsfor Infosys from the time of its initial cross-listing on Nasdaq in March, 1999. Theannouncement date of the first secondaryDR offering is December 6, 2002. Figure 1 showsthat the DR price has a sharpfall of about 15%on that date and the underlying domesticshare price increases by a much smaller amount (2.2%). This announcementsignificantlylowers the DR premiumfrom 74% on December5, 2002 to 46% on December6, 2002.On November5, 2004, Infosysannounced hat twasplanning o undertake secondsecondaryDR issue similarto the firstsecondaryDR issue. Likethe firstannouncement,nfosysDR pricesfell by 6.5%and the DR premium ell from 59.2% to 49.9%. Hence,the evidence from the twosecondaryDR issue announcementsby Infosys suggests that the DR premiumis being drivenpartlyby limited DR supplyanda downward-slopingdemandcurveforDRs.D. Taxes

If foreign (US) investors pay higher taxes on dividends and capital gains from investingdirectly in underlying domestic shares than from investing in DRs, then US investors mightbe willing to pay apremiumfor DRs. I investigatewhether taxes play a role in explaining whysome Indian DRs trade at significant premiums.US investors who tradein Indian DRs have a withholding tax imposed on the dividends byboth their own and the Indian government. To reduce or eliminate the effect of the doubletaxation of dividends, a US taxpayeris entitled to a tax credit fortaxes withheld by a foreignjurisdiction. Ingeneral,as long as the foreigntax rate does not exceed the investor's marginaltax rate,the credit will directlyoffset the US tax liability, resultingin a single level of taxationequivalent to the investor's US marginaltax rate. Capital gains, when realized, are taxableonly in the US (CallaghanandBarry,2003).Currently,foreign (US) investors who trade in Indian domestic stocks do not pay taxes ondividends. However, they do pay a 30% short-termcapital gains tax on stocks held for lessthan one year,and a 10% ong-term capitalgains tax. Taxespaidon capital gains in the Indianjurisdictioncan be used as a foreigntax credit to offset US tax liability.Hence, tax implicationsdo not appearto explain why US investors arewilling to pay significant DR premiums.E. Behavioral Explanation

In theiranalysis of tradesby a largenumberof US individualinvestors,Bailey, Kumar,andNg (2005) find some evidence that investors with more US-listed foreign securities (DRs,closed-end countryfunds, etc.) tend to use sophisticatedfinancial instrumentsandstrategiesand have substantial monthly turnover, and yet they realize relatively poor performancefrom their domestic portfolios. This finding suggests that investors' propensityto invest inUS-listed foreign securities depends on their level of overconfidence. Bailey et al. (2005)also find that these investors are attractedby security characteristicssuch as growth, andby more volatile securities. In addition, they find some evidence that investors in "Lead


12/25

PuthenpurackalExplainingremiumsnRestrictedRMarketsndTheirmplications 103

Figure

1.ChartofDRPremium,

Domestic

PriceandDRPriceofInfosys

Technologies

ThefigureshowsthechartsforInfosys'

DRPremium,

Domestic

Price,andtheDRPricefromthetimeofitsinitialcross-listing

(March

1999).Thechart

highlights

theannouncement

datesofvarious

significant

corporate

events,

andalsohighlights

asvaluesthechange

inDRpremium,

thedomestic

shareprice

reaction,

andDRpricereaction

tothesecorporate

events.Valuesinparentheses

indicate

aegative

sign.

200.0%80.0%60.0%40.0%S120.0%E100.0%

7.3

i80.0%

(0.8)

16.

60.0%0.0%

(28(9.3)

(10.2)

20.0%.0%

8,000

%Change

inPrice

fromprevious

day

7,000

(19%)

6,000 5,0000 C

4,000

7.f

3,000

8%

(6.59

(0.4

2,000

(4.6%)

(0.6Y

8%

(2

1,000

2.2%

(4.0%

4.16%

(27%/)

0 Mar-99

Jul-00

Dec-01

May-03

Sep-04

Time

SADR

Price

-

Domestic

Price


13/25

104 FinancialManagement Summer2006DRs"(i.e., the best-knownDRs of a particularcountry,such as India'sInfosys Technologies)condition their trades on some informationabout the home countryand tradeonly the best-known DRs of that particular country. Hence, some investors trade only the Lead DRsbecause of a trend associated with a country (for example, outsourcingin the case of India),and may not investigate whetherthe DRs are tradingat premiums.

Investing in DRs even if they trade at premiums is also consistent with a trend-chasingbehavior (see Bohn and Tesar, 1996), since if these DRs have performedwell in the past,investors may want to buy them in the hope of obtaining high future returns.To shed light on this uninformedinvestor or trend-chasing explanation of DR premiums,for the period April 1999 to May 2004, I computethe correlation between the percentageoftotal volume in Infosys DRs that result from trades of less than 400 shares,which is my proxyfor uninformed investor trading,and Infosys DR premiums. I collect the data on a monthlybasis, using transactionsdatafromNYSE's TAQdatabaseandDRpremiumsfromBloomberg.I find that the Spearman correlation is positive and significant (coefficient is 0.454;significant at the 1%level). This result suggests that small (uninformed) investor tradingmay partlyexplain the existence of DR premiums.F. Restrictions Imposed by Investors

From conversations with an international fund manager,I understandthat US high-net-worth individuals often impose restrictionson where theircapitalcan be invested. Therefore,some funds that have substantialcapital from high-net-worthindividuals may be limited tobuying only US-listed securities (like DRs) and are constrained frombuying the underlyingdomestic shares, even if they arecheaper.Also, some US mutual funds arerequired by theircharters o invest a certainpercentageof their assets in US-listed securities. These constraintsprovide a possible explanationfor why an institutional investor with a sizable holding maydecide to hold DRs, even when they trade at a premium.Bogle (2005) has another explanation for why an institutional investor without anyrestrictionsmight invest in higherpriced Infosys DRs. He suggeststhat institutionalinvestorshave become too focused on short term results. So, althoughthe DRs may currentlytrade ata premiumto the home-marketshare,andpremiumsarelikely to move towards zero over thelong term, some institutional investors with a shorter-termhorizon will choose to invest inDRs, since it is easier to invest in DRs and they believe that the probabilityof the premiumreducing sharply over the short run is very low.

G. DRs and UnderlyingShares in PartiallySegmented MarketsGiven that the IndianDR andtheunderlyingdomestic sharemarketarepartially segmented,when I measure their returns n a common currency,such as US dollars, I find thatthe returnsfrominvesting in DRs can diverge from that of investing directlyin domestic securities. Thisresult is because the DR premiumhas considerable variation over time, which adds morevolatility to DR returns.I obtain the historical monthly returns in US dollars for both Infosys DRs and Infosysdomestic sharesfortheperiodMay 1999 to December 2004 from DataStream.The correlationbetween the monthly returnseries of DRs and domestic shares is 0.85. The mean (median)monthlyreturnon DR and domestic shares s 5.29%(5.47%)and4.03%(1.62%), respectively,as reportedin Table IV.The higher volatility of DR returns s expected due to the volatility of the DR premium.Ialso examine the statistics for the difference in monthly DR returns and domestic share


14/25

PuthenpurackalExplaining remiumsnRestrictedDRMarkets nd Their mplications 105Table IV.HistoricalReturns of Infosys' Domestic Shares and DRsThis tableprovidesdescriptive tatisticson historicalmonthlyreturnsof InfosysTechnologies'domestic haresandDRs for theperiodMay1999to December 004,bothexpressednUS dollars.I obtainmonthlyreturns romDatastream. heexchange ate nMay2004 wasRs45.8/USD

Std. 25th 75thDev Mean Min. Perc. Median Perc. Max.(%) (%) (%) (%) (%) (%) (%)DomesticShare 17.29 4.03 -32.74 -6.02 1.62 13.95 68.87MonthlyReturn(in USD)DRMonthly 23.21 5.29 -43.28 -8.11 5.47 17.43 76.33ReturninUSD)DRMonthly 12.32 1.26 -30.33 -4.58 0.33 5.66 48.64ReturnminusDomesticMonthlyReturnreturns,both expressed in US dollars.Again, there is considerable variation in this measure.I also find that variation in the Infosys DR returnsis better explained by variation in theNasdaq composite index (R-Squared is 0.55) than by variation in the Indian stock marketindex (R-Squaredof 0.35). Onthe otherhand,the variationin the Infosys domestic returns sbetter explained by the variation in the Indian stock market (R-Squared is 0.47) than byvariation in the Nasdaq composite (R-Squaredis 0.37).

Thus, although there is a high correlationbetween DR and domestic sharereturns,thereare significant differences in the US dollar returns that would be earnedby those investingin DRs and domestic shares. Therefore, because of the different future returnoutcomes,investors may view restrictedDRs and the underlyingdomestic sharesas not being identicalsecurities and might then price them differently.H. Evidence from Actively Traded Indian DRs

I note that some Indian DRs trade at significant premiums while others trade at slightdiscounts. To explain the cross-sectional and time series variation of DR premiums,I collectdatafromBloombergon DR premiumsforactively tradedIndianDRs (N=21) over theperiodJanuary1997 to May 2004. In selecting my model specification, I follow earlierstudies thatexamine how foreign ownership restrictions can induce segmentation.4I include the onemonth lag premium(one-month LAG PREMIUM)to take into account serial correlationinpremiumsas in Domowitz, Glenn,andMadhavan 1997) andSunandTong (2000). I computea proxy for uninformed investor trading (Retail % of Volume) as the percentage of totalmonthlyvolume in DRs thatresult from trades of less than 400 shares.5 f uninformed nvestortrading partly explains DR premiums,I expect this variable to have a positive coefficient.For a measure of DR supply constraint, I collect information on DRs outstanding as apercentage of total shares (percentage of shares as DRs) from company annualreportsand4Bailey and Jagtiani (1994), Domowitz, Glenn, and Madhavan(1997), Bailey, Chung, and Kang (1999), and Sunand Tong (2000).5Mydata source is NYSE's TAQ database. Information s available only for ADRs, not for GDRs.


15/25

106 FinancialManagement Summer200620-F SEC filings. Since this data is only available on an annual basis, I assume the samefigurefor a 12-monthperiod.If there arehigherDR premiumsfor DRs with fewer outstandingDRs, then I expect a negative coefficient for this supply constraint variable.I collect monthly tradingvolume for both DRs and domestic shares from Bloomberg. Iconstruct two liquidity measures to test whether higher liquidity for DRs relative to theunderlyingdomestic sharespartly explains DR premiums.However, I do not reporton thesemeasures, as the results are not significant.To test whether DR premiumsare partly driven by a general increased interest in Indianstocks by foreign investors, I also collect different measures of foreign investor sentimenttowards Indian stocks. The first measure is the premiumto net asset value (NAV) for theMorgan Stanley closed-end Indiacountryfund(CECFPremium). My second measure is themonthly change in foreign portfolio flows into Indian domestic stocks. However, I do notreport the results using this second measure, since the results are similar to that obtainedusing the first measure.I include the natural ogarithmof market value of the DR issuing firm (Market Value)as aproxy for LEAD DRs, as discussed in Bailey, Kumar,andNg (2005). In TableV,using paneldata regressions with fixed effects with a first-order autoregressive disturbance term (aWooldridgetest for auto-correlation n panel data detects autocorrelation), find a significantdegree of serial correlationin DR premiums (Model 1). I also find thatlargerfirms measuredby market value have higher premiums.This finding supports Bailey et al's hypothesis thatDR investors areattracted o LEAD DRs. I do not find significant supportfor the hypothesisthat a supply constraint of DRs partly explain DR premiums.Neither do I find significantsupportfor the hypothesis that DR premiumsarecorrelatedwith foreign investor sentiment,even though the sign of the coefficient in some specifications is positive.To provide a strongertest of the uninformed investor tradingor trendchasing explanationfor the existence of DR premiums,I add the variable Retail %of Volume to the specification(Table V Models 4 and 5). The sample size drops because this information is available foronly eight Indian ADRs. The coefficient of this variable is positive and significant, androbustto a numberof alternatespecifications. This result suggests thatin DRs where smaller(uninformed) investors contribute a higher share of trading activity, premiums tend to behigher. This result provides furthersupportto the idea that uninformed investor tradingortrendchasing partly explains the existence of DR premiums.Itmaybe noted that small tradesmay also be madeby informed(institutional)investors to dissimulate theirtradingactivities.The lower tradingcosts in the US make such ordersplitting strategiescost effective. Hence,it is possible that my proxy for uninformedtradingis noisy.

III.How FirmsCan Benefit When TheirDRsTrade atSignificant PremiumsIn the presence of significantDR premiums,largedomestic shareholdershave an incentiveto lower their ownership stakes by selling additional DRs periodically through secondaryDR offerings, since doing so allows them to capture some of the premium. We examineInfosys' secondary DR offers, because they appearto be driven by this incentive.

A. Infosys' Secondary DR OffersInfosys is well respected in both India and the US for its corporate governance practices.


16/25

PuthenpurackalExplaining remiums nRestrictedDR Markets nd Their mplications 107Table V. Determinants of DR PremiumsThis able eportsesults singpaneldata egressionsith ixedeffectswithmonthlyndianDRpremiumsas thedependentariable. hesample onsists f 21 activelyradedDRsof Indianompaniesor heperiod1/31/1997o 5/31/2004.Thedata ource orthe DRpremiumss Bloomberg. ne-monthAGPREMIUMis theDRpremiumn thepreviousmonth.Retail%of Volume s thepercentagef totalmonthlyolume nDRsthat s a result f trades f less than400 shares nd s aproxy oruninformedrading.%of shares sDRs s the % of total hareshat rade s DRs.Thisvariablemeasureshesupply onstraintorDRs.CECFPremiums themonthly remiumhatan India losed-endountryund unby Morgan tanleynvestmentFund rades elativeo netassetvalue NAV).Marketalue s themarket alueof theDR ssuingirms.

Model 1 Model2 Model 3 Model4 Model 51-month AGPREMIUM 0.359*** 0.354*** 0.457*** 0.445*** 0.412***Retail%of Volume - - - 45.74*** 51.35***%ofshares sDR - - 0.032 - -CECF remium - 0.014 0.060 - -0.182LN(Marketalue) 2.554** 5.617**Constant 4.637*** -6.524 5.501*** 2.018 -34.11*F-Value 217.4 74.7 88.5 69.4 36.8Number f Observations 1453 1400 981 330 330***Significantt he0.01 evel.**Significantt he0.05 evel.*Significantt he0.10 evel.Key financial information orInfosys providedinTableVI indicatesthatInfosys is aprofitableand rapidly growing firm. Infosys Technologies raised capital in its initial DR listing onNasdaq in March 1999 but did not raise capital in their secondaryDR issues in July2003 andMay2005.Table VI shows that Infosys is a cash-rich firm, so raising capital was probably not theprimaryreason for its cross-listing. Increasingfirm value and liquidity of DRs andallowingdomestic shareholders,especially largeones such as firmfounders,to diversifytheirholdingsover time at more favorableprices appearto be more likely motives of the US cross-listing.Indeed, Infosys stated that its reasons for undertaking the secondary DR offers was toincrease the liquidity of its DRs.Table VII provides the time-lines of the secondary DR offer and details of the offers.Infosys converted existing domestic shares into DRs and sold them, so clearly Infosys didnot intend to use the secondary DR offers to raise capital. Througha tender offer, Infosysinvited domestic shareholdersto tender their domestic shares for conversion into DRs. Theallotment for conversion into DRs was to be done on a proportionatebasis in accordancewith buy-back regulations drafted by SEBI. Since the tendering was being done on aproportionate basis, more shares tendered by large shareholders would be accepted forconversioninto DRs. Since Infosys DRs were tradingat significant premiums o the equivalentdomestic shares, the secondary DR offer enabled domestic investors whose shares wereaccepted to capturesome of this premium.Not surprisingly, the first tender offer was oversubscribed, with 10,164 domesticshareholderstendering 14.86 million shares for conversion into DRs. Infosys accepted onlythreemillion shares,comprising2.609 million sharesandanoptionto sell anadditional 0.391million shares,which shareholders exercised.TableVIIIpresentsdataon the selling domestic shareholderswhose shareswere acceptedfor conversion into DRs. The founders, directors, and executives of Infosys accounted for


17/25

108 FinancialManagementSummer 006TableVI.Financial tatisticsof InfosysThis ableprovidesrief inancialnformationnInfosysTechnologiesver he astsevenyears.TheSales,Profits ndEPS are denominatedn IndiaRupeesRs.).ROEandROCE enoteReturn n Equity ndReturn nCapital mployed,espectively.heexchangeate nMay2004wasRs45.8/USD.

FY1998 FY1999 FY2000 FY2001 FY2002 FY2003 FY2004Sales Rs.Mill) 2,577 5,089 8,823 19,006 26,037 36,227 47,609ProfitRs.Mill.) 604 1,329 2,859 6,233 8,080 9,579 12,435EPS Rs.) 9.1 20.7 43.2 94.2 122.1 144.7 187.4ROE%) 42.2 54.2 40.6 56.1 46.6 38.8 40.7ROCE%) 46.1 63.5 46.3 62.6 54.5 46.9 48.1(Cash Cash quivalents)/Salesin%) 17.0 79.6 48.9 20.3 29.7 36.9 34.4(Cash+CashEquivalents)/Assetsin%) 25.3 70.5 51.8 27.7 37.1 46.7 50.3over 30% of the shares, and shareholders with over 1%ownershipaccounted for over 60%of the shares, in both offerings that were accepted for conversion into DRs. While thisoutcome reflects the proportionateallotment method used, it also highlights the fact thatinvestors with significant ownership stakes obtained the largestabsolute gains from the DRoffer, since they were able to sell more of their shares at the prevailing higher DR price.

Another method of capturingsome of the DR premiumfor domestic shareholders wouldhave been to undertakea capital-raisingDR issue in the US market,and to use the proceedsto repurchasedomestic shares from the open market.6Assuming that domestic shares wouldhave risen to reflect the arbitrage profits obtained by Infosys, this would have resulted inInfosys' arbitrage profit being spread across all outstandingdomestic shares. On the otherhand, the arbitrageprofit fromthe tenderoffer would be concentratedon only the domesticshares that are being converted into DRs. Hence, the tender-offer option is particularlyattractive for a large shareholder such as a founder who wishes to diversify his holdings.Since he is able to realize his gains from the DR offer by selling fewer shares, he can stillretain control.An example illustrates the point. Assume a foreign firm has a total of ten million sharesoutstanding,of which one million shares have been converted into DRs. Assume one domesticshareequals one DR. Also assume that the DR is tradingat a premiumto the domestic share,with the DR priced at $100 and the domestic share at $75. Obviously, there must be barriersto arbitragefor the premiumsto persist. The firmdesires to capturesome of this premiumforits domestic shareholders.I examine how the two possible methodsdiscussed above can affect a domestic shareholderwho owns 25% of the domestic sharesoutstanding(2.25 million shares). Similarto Infosys,if the firm does a tender offer to sell one million moreDRs, this domestic shareholderwill end

up having 0.25 million of his sharesacceptedfor conversion for a payoff of $25 million ($6.25million more than if he had sold it in the domestic market). So, after the tender offer, theshareholderhas two million sharestradingat $75 per share and$25 million in the bank(i.e.,61 thankJeanHelwege orraising hispossibility.


18/25

PuthenpurackalExplainingremiumsn Restricted RMarketsndTheirmplications 109

TableVII.Infosys'

Secondary

DROfferings

Thistableprovides

thetime-lines

anddetailsonInfosys'

twosecondary

DRofferings.

Time-Line

ofSecondary

DRIssues

Invitation

toDomestic

Announcement

ofDR

Shareholders

Shareholders

to

Issuance

andPricing

DRIssue

Issue

Approval

ofDRIssue

Tender

Shares

Tendering

Period

ofDRIssue

1stDRissue

12/6/2002

2/22/2003

7/12/2003

7/16/03---7/25/03

7/30/2003

2"dDRissue

11/5/2004

12/19/2004

5/6/2005

5/9/2005--5/19/2005

5/27/2005

DetailsofSecondary

DRIssues

d

Details

1stDR

2"dDR

OfferPriceoftheDR

USD49

USD67

OfferDateofDR

July30,2003

May27,2005

Number

ofDRssold

6million(#3million

domestic

shares)

16million

(#16milliondomestic

shares)

IssueSize

USD294million

USD1072million

IssueCost

USD

11.7(about4%ofissuesize)

USD45million

(about4.2%ofissuesize)

NetProceeds

totendering

domestic

shareholder

USD94.1/domestic

share

USD64.2/domestic

share

Prevailing

priceindomestic

market

Rs.3570/domestic

share

Rs.2171/domestic

share

Premium

obtained

bysellingdomestic

shareholders

22%

34%


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110 FinancialManagement Summer2006Table VIII.Selling Domestic Shareholders During Infosys' Secondary DR OffersThe tableprovidesthe names,numberof sharessold, shares sold as a %of total issue and beforeand aftertender-offer ownership in terms of both number of shares and as a % of total shares, of the sellingshareholdersn Infosys'twosecondaryDRoffers.Percentages f correspondingotalsappearnparentheses.There was a 4/1 split in Infosys stock and a changeof DR to domesticshare conversionratio from 2 DRs

FIRST Secondary ADR Offer SECOND Secondary ADR OfferShares Before After Tender Shares Before After TenderSold Tender Offer Offer Sold Tender Offer Offer

(% of Total Shareholding Shareholding (% of Total Shareholding ShareholdingName Issue) (%) (%) Issue) (%) (%)Founders, Directors and OfficersN.R. Murthy 277,715 4,738,400 4,460,685 1,551,477 17,826,740 16,275,263

(9.26) (7.15) (6.73) (9.70) (6.58) (6.01)N. Nilekani 192,850 3,290,400 3,097,550 1,076,379 12,367,700 11,291,321(6.43) (4.97) (4.68) (6.73) (4.57) (4.17)S. Gopalakrishnan 186,378 3,180,000 2,993,622 1,042,158 11,974,488 10,932,330(6.21) (4.80) (4.52) (6.51) (4.42) (4.04)K. Dinesh 136,760 2,333,400 2,196,640 764,726 8,786,560 8,021,834(4.56) (3.52) (3.32) (4.78) (3.24) (2.96)

S. Shibulal 123,438 2,106,000 1,982,562 688,279 7,908,248 7,219,969(4.11) (3.18) (2.99) (4.31) (2.92) (2.67)Others 6,041 221,100 215,059 41,391 1,248,586 1,207,195(0.20) (0.33) (0.32) (0.26) (0.47) (0.45)

Sub-total 923,182 15,869,300 14,946,118 5,164,410 60,112,322 54,947,912(30.77) (23.95) (22.56) (32.28) (22.20) (20.29)

Other Shareholders with Greater than 1% StakesMerrill Lynch 155,954 2,783,637 2,627,683 644,786 7,408,707 6,763,921

(5.20) (4.20) (3.97) (4.03) (2.74) (2.50)Morgan Stanley 164,076 2,655,757 2,491,681 657,357 7,559,368 6,902,011

(5.47) (4.01) (3.76) (4.11) (2.79) (2.55)Citigroup 75,096 1,203,162 1,128,066 -

(2.50) (1.82) (1.70) -Capital International 64,199 1,059,370 995,171 -Emerging Markets Funds (2.14) (1.60) (1.50) - -UBS Warburg 40,133 915,913 875,780 - -(1.34) (1.38) (1.32) - -

Oppenheimer Funds 47,109 803,772 756,663 297,119 3,413,952 3,116,833(1.57) (1.21) (1.14) (1.86) (1.26) (1.15)

Copthall Mauritius 39,640 699,489 659,849 556,598 6,395,402 5,838,804Investment (1.32) (1.06) (1.00) (3.48) (2.36) (2.16)UBS Securities- - 633,242 7,276,078 6,642,836

(3.96) (2.69) (2.45)FMR409,561 15,138,293 14,728,732

(2.56) (5.59) (5.44)Emerging MarketsGrowth Fund Inc. 233,389 3,689,710 3,456,321 459,751 5,282,623 4,822,872(7.78) (5.57) (5.22) (2.87) (1.95) (1.78)Goldman Sachs

459,602 5,280,890 4,821,288- - - (2.87) (1.95) (1.78)Others 185,407 3,179,395 2,993,988 813,736 9,349,906 8,536,170

(6.18) (4.80) (4.52) (5.09) (3.46) (3.15)Sub-total 1,005,003 16,990,205 15,985,202 4,931,752 67,105,219 62,173,467(33.50) (25.65) (24.13) (30.82) (24.79) (22.96)Shareholders with Less Than 1%oStakes

Sub-total 1,071,815 18,278,414 17,206,599 5,903,838 68,208,564 62,304,726(35.73) (27.59) (25.97) (36.90) (25.19) (23.01)Total 3,000,000 51,137,919 48,137,919 16,000,000 195,426,105 179,426,105

(100loo.00) (77.19) (72.66) (100.00) (72.18) (66.26)


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PuthenpurackalExplaining remiumsnRestrictedDRMarkets nd Their mplications 111a total wealth of $175 million.) On the other hand, consider the case of the firm that issuesone million new DRs to raise $100 million, and then uses these proceeds to buy back onemillion domestic shares.If the domestic sharepricereflects the arbitrageprofitof $25 millionobtainedby the firm,the domestic shareprice will rise by $2.78 to $77.78. The wealth of thelargeshareholder s still $175 million (2.25 million sharestradingat$77.78 pershare),as in theprevious case. The difference is that if he wishes to diversify his holdings and wants to cashout $25 million, he will have to sell 0.32 million shares which is greaterthan the 0.25 millionshares, using the tender offer. Hence, if retaining control is an objective, then the tender-offer alternative enables large shareholdersto diversify their holdings more optimally.B. The Impact of the Secondary DR Offering on DR Holders andDomestic Shareholders

Fromthe perspectiveof Infosys domestic investors,it makes sense to sell existing domesticshares as DRs, since DRs trade at a higher price. Because governmentrestrictionspreventinvestorsfromconvertingdomestic shares ntoDRs, onlythe issuingfirmcan,withtheapprovalof the government, exploit the DR premiumon behalf of its domestic shareholdersby issuingadditionalDRs through econdaryDR offerings.However,it is not clearwhetherselling Infosysdomestic shareholders'gains are obtained at the expense of Infosys DR holders.To assess its impact on DR and domestic shareholderwealth, I use the standard eventstudymethod to examinethe stock price reaction of Infosys DR and domestic shareprices tothe announcementof Infosys' secondaryDR offerings. There were no othersignificant firmannouncements made at that time, so the stock price reaction may be attributed to theannouncement of the DR offerings.To effect my examination,I obtain cumulative abnormal returns(CARs) with the marketmodel benchmark,using Datastream's India total market ndex as the market ndex. Table IXreportsmy finding that Infosys' DRs have a CAR over a three-day period centered on theannouncement of the first secondaryDR issue (CAR (-1,1)) of-24.68%, which is significantatthe 1% evel. Infosys domestic shareshave a correspondingCAR (-1,+1) of-0.07%, whichis not statistically significant.TableIX also reports he stock price reactionto the announcementof the second secondaryDR offering. The results are similar. Infosys DRs have a CAR(-1,1) of -7.11%, which issignificant at the 5% level, and no significant reaction for the domestic shares. Hence, theevent study results suggest that Infosys' secondary DR offerings result in a substantialwealth transfer fromexisting DR holders to selling domestic shareholders.It is possible thatthe reaction to the announcements of the secondaryDR offerings is notdueto the offerings perse, but because of the informationconveyed by these announcements.To test whether this information has an industry component, I conduct event studies toexaminehow otherIndiantechnology firms,WiproandSatyam Computers,with DRs react tothe announcement of Infosys' secondary DR offerings. The signs of the reaction for theseevent portfolios are negative, suggesting that there may be information about the industryconveyed by the secondaryDR issues. However, the reaction is not significant, which couldbe because of the small sample size.I also conduct an event study using an event portfolio of all IndianADRs, but excludingInfosys.7 The reaction to the announcementof Infosys' secondary DR offerings is positivebut not significant.Finally, I examine the reaction of Indian DRs that trade at high premiums (Wipro, Satyam7Datastreamhas stock returndata on only the Indian ADRs.


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112 FinancialManagement Summer2006Table IX.Stock Price Reaction of Event Portfolios Comprising IndianDRs andTheir Domestic Shares to the Announcement of Infosys' SecondaryDROfferingsThe tablepresentscumulative bnormal eturnsover a 3-day period(CAR(-1,1) centeredon theannouncementf the two secondaryDR issues of Infosys (Day 0)) for differenteventportfolios.Datastreams mydata ource orreturns. computehe CARsusing he marketmodelwithDatastreamIndiaTotalMarket ndexas themarketndex.Z-statisticsppearnparentheses.

CAR(-1,1) Reaction to CAR(-1,1) Reaction toAnnouncement of First Announcement of SecondSecondary DRissue (Day 0) Secondary DRissue (Day 0)DR Underlying DR Underlying

Infosys -24.68%*** -0.07% -7.11%** 0.63%(N=1) (-4.14) (-0.01) (-1.84) (0.28)Wipro -3.13% -1.02% -2.31% -0.77%(N=1) (-0.71) (-0.19) (-0.55) (-0.27)Wipro&Satyam -2.21% -2.31% -2.15% -1.74%(N=2) (-0.63) (-0.87) (-0.68) (-0.89)IndianADRs 0.37% 0.33% 0.83% -1.02%withoutnfosys (-0.09) (-0.12) (0.76) (-0.52)(N=7)IndianADRs 0.21% -0.86% -0.22% 0.26%withoutnfosys (0.10) (-0.53) (0.16) (0.31)that rade t ahighpremiums(N=4)***Significantt the0.01 level.**Significantat the 0.05 level.Computers, HDFC Bank, and ICICI bank). My hypothesis is that if investors infer thatfirms with DR premiums are going to start to exploit them by issuing additional DRs, thenDR premiums will fall on this announcement. Somewhat surprisingly, I do not find asignificant reaction. However, I note again that the event study sample is small, so thepower of the test is low.IV.The Benefits of a US Cross-Listing

I use Infosys Technologies' secondaryDR offering to highlight a particularbenefit of a UScross-listing, namely, that cross-listing allows large domestic shareholders, such as firmfounders, to diversify their ownership stakes profitably.8A cross-listing appears to beparticularlybeneficial for high-quality foreign firms that want to raise more capital to takeadvantage of more growth opportunitiesor to increase firm value due to the lower cost ofcapital that results from increasedbonding and an improved informationenvironment. For8Karolyi(1998, 2004) provide excellent reviews of the literature that examines the potential benefit and impactof a US cross-listing.


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PuthenpurackalExplaining remiumsnRestrictedDRMarkets nd Their mplications 113these reasons, the advantagesof a US cross-listing are also likely to be morepronouncedforfirms from countries with less-developed financial marketsor weak investorprotectionlaws.Forlargedomestic shareholdersn high-quality foreignfirms in countrieswith less-developedfinancial marketsdesiring to diversify theirholdings, a US cross-listing would be attractivedue to the higher firmvalue and increased liquidity that accompanies a US cross-listing.

To better understand the motivations of its initial DR cross-listing and subsequentsecondary DR offerings, I examine how the ownership composition of Infosys domesticshareschanges around he US cross-listing. Therefore,I document the extent to which firmfoundersdiversify theirholdings after the cross-listing. Similar to Doidge (2004), to providefurtherevidence on the motivation of Infosys' cross-listing decision, I also studythe identityof new institutionalinvestors who acquire significant ownershipstakes in Infosys' domesticshares and DRs after the cross-listing.Figure 2 (Panel A) shows the changes in share ownership by shareholder type. FIIssignificantly increase their holdings in Infosys domestic shares from 23% in 1996 to 42%in 2004. Over the sameperiod, individual investors' domestic shareholdings decline sharplyfrom 28%to 14%.The shareownership by the firmfounders, directors,and officers declinesmoremoderatelyfrom 35% to 27%. Shares in the formof DRs remainat around3%from thetime of Infosys' cross-listing until the secondary DR offer in July 2003, when it increasedto around8%.Toobtaina finer understandingof how firmfoundersdiversify theirholdings,I collect individual firm founderholdings from 2001 to 2004. Figure 2 (Panel B) shows thatI do not find a dramaticdecline in ownership of individual firm founders, andthe reductionof ownership is moderateand gradual. However, this moderate reduction of ownership iseffected more profitably by divesting through secondary DR offerings.Next, I collect informationon holdingsof significantinstitutional nvestors or block holdersin Infosys' domestic sharesand DRs over the period2001-2004. Figure2 (Panel C) presentsmy findings. I find that some large investors, such as the Unit Trust of India (UTI) and theGovernmentof Singapore,sharplyreducetheir domestic ownershipstakes,while new foreigninstitutional investors, such as the Emerging MarketsGrowthFund, Capital International,Morgan Stanley and OppenheimerFunds, acquire significant stakes. An Indian insurancecompany,the Life InsuranceCorporationof India, also acquires a significant stake. When Iexaminethe ownershipofInfosys DRs, I find that in 2004, a numberof institutional nvestorshold Infosys DRs, with Fidelity mutual funds holding over 1.5% of Infosys shares in theform of DRs.

I attribute he increasedforeign ownershipof Infosys stock to the increasedvisibility andinvestorrecognition,andthe improved nformationenvironment hataccompaniesa US cross-listing. Because of these factors, more foreign (US) investors became aware of Infosys andmay have become more willing to acquire ownership in Infosys' domestic shares and DRs.Thisdeepeningof thepotentialinvestor base is likely to make the sale of significantstakesbymajordomestic shareholders,such as firm founders,more viable and profitable. Supportingthis hypothesis, I note that two large domestic shareholders,UTI and the GovernmentofSingapore,have reducedtheir stakes significantly since Infosys' cross-listing.

V. ConclusionIn this article, I show that some Indiandepositary receipts tradeat significant premiumstothe currency-adjustedequivalent underlying shares. I also highlight how restrictions onDR-underlying domestic share convertibility constrains arbitrage and thus allows the


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PuthenpurackalExplaining remiumsnRestrictedDR Markets nd Their mplications 115existence of large DR premiums. I note that the IndianDR market and underlyingdomesticshare market is not completely segmented, since DR investors can choose to invest directlyin the underlying domestic market.I explore andtestpotential explanationsforwhy DR investors arewilling to pay significantpremiums for DRs even when they have the option to invest directly in the underlyingdomestic market. I findthat a limited supply ofDRs anda downward-slopingdemandcurve,significant transactions costs associated with investing directly in the domestic market,andtrend chasing by smaller and potentially uninformed investors partly explains why DRinvestors arewilling to pay the DR premiums.In what appearsto be corporateactions undertaken to exploit the DR premium, InfosysTechnologies madenon-capital-raising secondary depositary receipt issuances in July 2003and May 2005. In these issues, the company converted existing domestic shares, selectedthrough a tender offer, into DRs for sale through secondary DR offerings. I find that thegains obtained by selling domestic shareholders,which include firm founders, are at theexpense of existing DR holders.

I also use Infosys Technologies' secondary DR offerings to highlight a particularbenefitof a US cross-listing, namely, that cross-listing allows large domestic shareholders,such asfirmfounders,to profitablydiversifytheirownershipstakes. To better llustrate he motivationand benefits of its US cross-listing, I show how the ownership structureof Infosys DRs anddomestic shares changes around the time of the cross-listing.E

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Explaining Premiums in Restricted DR Markets and Their Implication