Enforcing the Law of One Price: Nonlinear Mean Reversion in the ADR Market

This work presents evidence that cross-isted stocks (ADRs) are traded in markets that are not completely integrated, and it is the presence of high frequency arbitrage activity that forces these stock pairs to be most commonly in relative equilibrium. A Threshold Autoregressive (TAR) model tests the hypothesis that the reversion to equilibrium of the price discrepancy series is a nonlinear function that has nontrivial thresholds, and that large price discrepancies are relatively short-lived. The TAR specification models the neutralization of arbitrage forces with thresholds that separate outer regions where large discrepancies have a strong reversion to equilibrium from a central region where transaction costs significantly mitigate this reversion.