Mispricing in the Global Market: A New Perspective

The determination of asset prices and the identification of related economic grounds are considerately more intricate in the global market due to the potential market segmentation and frictions. In this paper, we propose and test a novel intuition that cross-country mispricing can be identified when assets are benchmarked against dual listed firms. More specifically, since a parent stock and its American Depository Receipt (ADR) are likely to be subject to a similar degree of mispricing to avoid outright pairwise arbitrages, we expect the local industry to be underpriced compared to its U.S. counterparty when we observe that a parent stock has a higher overpricingrank within its local industry than the overpricing-rank of its ADR within the corresponding industry in the US. Empirically, we find that underpricing measured in this way has a significant predicting power over industry returns in the global market. A quarterly rebalanced long-short portfolio based on the measure can generate risk-adjusted returns as high as 7.8% per year. Moreover, while foreign mutual funds chase mispricing opportunities and increase market integration, large domestic mutual fund flows exacerbate mispricing and market segmentation. Our results suggest that the global market is partially segmented at the industry level, and that capital flows play a particularly important role in mispricing and its undoing