Effects of exchange rate fluctuations on prices of cross-listed stocks

What is it about?

Our main objective is to add to the understanding of how prices on competing markets gravitate to restore the law of one price following exchange rate shocks. We ask the following questions. For stocks trading simultaneously on the NYSE and home country markets, does the NYSE (i.e., the foreign market) bear all of the burden to adjust when restoring price parity following currency shocks? To what extent do prices change to restore price parity following currency shocks? Are effects similar within a country, or are they stock-specific? And, to what extent are exchange rate effects driven by order execution quality? We find that the foreign market does not bear the brunt of the burden to adjust to exchange rates. The exchange rate burden is not a broad market-based effect but instead is a stock-specific effect. The foreign market’s share of adjustment to exchange rates is higher for firms with higher bid-ask spreads, lower trading volume, and higher price impacts on the foreign market versus the home market.

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Why is it important?

Prior studies that examine exchange rate effects are limited to home markets that maintain better order execution quality (e.g., lower costs, higher volume, and greater depth). Not surprisingly, these studies find the foreign market bears the lion’s share of restoring price parity in upholding the law of one price. In contrast, we examine multiple home markets that span a broad continuum from strong to weak order execution quality. We find the burden to restore price parity is a stock-specific phenomenon and relies heavily on relative order execution quality. We contribute to the literature by highlighting a risk that is often overlooked when investing in internationally cross-listed stocks and may also help explain the home bias phenomenon.

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