The Effect of the Financial Crisis on the Relation Between the Egyptian GDR’s and Their Underlying Stocks in Egypt

This research examines the relationship between the behavior of the prices of the Egyptian GDR's in London and their underlying stocks in Egypt, and whether the previous financial crisis of 2008 showed any difference in the price behavior of these securities. There were 10 stocks tested that represent 3 main sectors which are; the financial sector, the telecom sector and the constructions sector. We found that there is a strong direct relationship between the Egyptian GDR's and their underlying stocks in Egypt and that this relation was maximized during the crisis of 2008 and it appears most in the financial and telecom sector. INTRODUCTION The acceleration in the globalization of markets over the past years is not only represented by the free flow of goods and services, but also by the international liberalization of capital flow. This helped companies in emerging markets to obtain listings on American and European Exchanges through the issuance of American Depository Receipts, ADR's, and Global Depository Receipts, GDR's. These may include firms going public for the first time (Global Initial Public Offering), or firms that are already public deciding to list their equity in a foreign market (Nyvltova, 2006). On the other hand, the trend of the rising correlation among global markets affected the trust of investors in the international globalization negatively. Those investors appeared in the late 1980's and the early 1990's when the long period of international equity performance began. This period witnessed lower overall returns with little reduction in portfolio volatility (Srivastava, 2007). In addition to that, domestic investors are likely to have better information about firms in their own country than foreign investors, therefore, the two types of investors may price a security differently (Nuno, 2003). The purpose of this paper is to understand the behaviour of the Egyptian GDR's and their underlying stocks in Egypt. Moreover, the research will give us some highlights about the efficiency between the two markets and whether there are arbitrage opportunities between the two markets and hence the two markets are inefficient or the linkages between the two markets are really efficient. The importance of this study appears widely for the investors that are the main users of the theory of arbitrage. In fact it will show investors the relationship between the two markets and whether the rising correlation between the world markets appeared between those specific markets and affected the performance of the securities that are listed in both market. LITERATURE REVIEW As countries are moving towards a more global market, and as the barriers and constraints are removed, allowing access to the financial markets, international investors have greater access to individual securities providing better performance for the risk undertaken. As Thomas, 2003, observed that investors that would use the buy-and-hold strategy in dealing with international stocks will be able to recognize similar returns as those of fund managers. Karolyi, 2004, mentioned that the expansion of ADR's and GDR's in emerging economies may be a result of the declining market conditions and not a cause of them. He explained his point of view that the deterioration in the fundamental economic, political, legal or other institutional forces in the emerging markets create incentives for companies to leave by issuing GDR's and ADR's abroad. Also Demissew and Chinmoy, 2004, observed in their findings regarding the trading volume in a market after DR listing that the average daily trading volume more than doubled for the stocks, and consequently the average daily ISSN 1553 – 5827 www.jaabc. com The Business Review, Cambridge * Vol. 22 * Num. 2 * December * 2014 161 There are 3 kinds of investors in the equity market that correspond to three different temporal locations in the market. Hedgers that seek reducing the risk they confront, and they move towards the derivatives market in order to reduce the risk they already face. Speculators that actively try to expose their selves to calculated risk by trading in the future markets. Arbitrageurs are engaged in risk free trading activities and they take positions in more than one economically related markets (Hull, 1997). On the other hand, Hardie, 2004, showed that arbitrageurs should not be categorized as a separate investor type, but in fact arbitrageurs are just 'noise' or irrational traders. Hardie draws attention to inconsistent understanding of what arbitrage is in both financial economics and the social studies of finance mentioning that there is a difference between the 'theory' and the 'practice' of arbitrage. In his view, any trade can take a view that an asset is mispriced , but, unless profit is guaranteed, the trade is not arbitrage. Dow and Garton, 1994, assumed that the efficiency of security prices depends upon arbitrage, that means trading based on information that the price of an asset is not the same as its fundamental value. They argued that arbitrageur's information cannot be reflected in the price he pays upon submission of the order and that the arbitrageur must be able to hold the security until he will be able to realize profit. However, their findings showed that an arbitrageur that receives bullish news will only buy under the condition of the likeliness that at the end of the trading horizon, another arbitrageur's buying will have pushed up the expected prices (Dow and Gorton, 1994). Kumar and Seppi, 1994, observed that there are many reasons that would help arbitrage in less developed and less fragmented markets to be more profitable than arbitrage in more developed and fragmented market. First, there are less people aware of arbitrage in less developed markets. Second, higher level of noise traders due to lower experience of experts to identify arbitrage opportunities. The last reason is the high costs of achieving information before the market makers do get these information. According to Grossmann et al, 2006, if markets are efficient, the prices of the same identical stocks that trade in different locations should be similar, as any deviation in their prices will be arbitraged away. Consequently, the price of a DR which is the US$ value of a claim on the equity of a foreign company, should be equal to the exchange rate adjusted price of the common stock of that company. Therefore, when the deviation exists between the DR and the price of its underlying asset, the DR is said to be mispriced. A number of factors have combined to deteriorate the performance of the Egyptian stock exchange which began its decline in early 2008. Mainly was a rush by foreigners to liquidate their financial assets in order to bail out their enterprises in their home countries in the wake of the mortgage crisis. As a result the EGX 30 index dropped by around 56 % in one year, which suggests that the drop of the Egyptian stock Exchange was one of the strongest drops all over the world. (Abu Hattab, 2010) After reviewing the literature review on the effect of cross listing and arbitrage on the performance of the companies, investors and overall market, we concluded that our hypothesis in examining the effect of the financial crisis on the relation between the Egyptian GDR’s and their underlying stocks in Egypt will be as follows: There is a direct strong relationship between the returns of the Egyptian GDR's listed in London stock exchange and the return of their underlying stocks in Egypt. The research now will proceed to the empirical section of the study. RESEARCH METHODOLOGY The population consists of 10 shares. The 10 shares come from 3 different sectors; the financial sector, the telecom sector and the constructions sector. Each of these shares is listed both in the Egyptian Stock Exchange and in London Stock Exchange and they are the only 10 stocks that are listed in both exchanges. The 10 stocks have an Egyptian Pound value and have an equivalent US Dollar value that is traded in London. We ignored from our analysis 4 shares; Ezz Steel Rebars, Lecico, Suez Cement and Pachin, as there were no enough data regarding the prices of the GDR's in order to perform this statistical analysis.In our analysis we converted all DR’s to Egyptian pounds, using the appropriate exchange rate between the $US and the Egyptian pound, so that all securities value are in one currency. ISSN 1553 – 5827 www.jaabc. com The Business Review, Cambridge * Vol. 22 * Num. 2 * December * 2014 162 Table -1Egyptian GDR’s Sector Code Name Financial Services COMI.CA 1) Commercial International Bank Financial Services HRHO.CA 2) EFG-Hermes Telecom ORTE.CA 3) Orascom Telecom Telecom ETEL.CA 4) Telecom Egypt Constructions ESRS.CA 5) El Ezz Steel Rebars Constructions PHDC.CA 6)Palm Hills Development Constructions LCSW.CA 7)Lecico Egypt Constructions SUCE.CA 8) Suez Cement Constructions PACH.CA 9)Paint & Chemical Industries(Pachin) Constructions OCIC.CA 10)Orascom Constructions Industrial The series of the prices of stocks are trended and therefore in most cases they are non-stationary. The problem with non-stationary or trended data is that the standard ordinary least square (OLS) regression procedure outcome can easily lead to incorrect conclusions. Augmented Dickey–Fuller test (ADF) is a test for a unit root in a time series sample. It is an augmented version of the Dickey–Fuller test for a larger and more complicated set of time series models. The augmented Dickey–Fuller (ADF) statistic, used in the test, is a negative number. The more negative it is, the stronger the rejection of the hypothesis that there is a unit root at some level of confidence.The possible form of the augmented Dickey Fuller (ADF) test is given by the following equation: