Adjusted depository receipt

American Depositary Receipt: Definition, Example, and FAQs

The term "Adjusted Depository Receipt" is not a recognized financial instrument in common usage. It appears to be a variation or misunderstanding of the widely established "American Depositary Receipt" (ADR), which serves to facilitate investment in foreign companies. American Depositary Receipts are central to International Investing, enabling U.S. investors to gain exposure to global markets without the complexities of direct foreign stock ownership. This article will define and explain American Depositary Receipts, including their structure, types, and implications for investors.

What Is an American Depositary Receipt?

An American Depositary Receipt (ADR) is a negotiable certificate issued by a U.S. depositary bank that represents a specified number of shares—or sometimes a fraction of a share—of a foreign company's stock. These certificates trade on U.S. stock exchanges or the Over-the-Counter Market as any domestic equity would, making it simpler for U.S. investors to invest in non-U.S. companies. The underlying foreign shares are held by a custodian bank, usually an overseas branch of the U.S. depositary bank. ADRs and their associated dividends are priced and paid in U.S. dollars, eliminating the need for investors to deal with foreign currency exchange directly. ADRs fall under the broader category of equities and are a crucial tool for portfolio diversification.

History and Origin

Before the advent of American Depositary Receipts, U.S. investors interested in foreign companies faced significant hurdles, including dealing with different regulatory environments, foreign exchange complexities, and the logistical challenges of trading on overseas markets. Th¹³e first ADR was created in 1927 by J.P. Morgan to allow U.S. investors to invest in the shares of the British department store Selfridges. This innovation provided a streamlined mechanism for cross-border investment, making it easier for foreign companies to access U.S. capital markets and attract American investors.

#¹²# Key Takeaways

• An American Depositary Receipt (ADR) is a certificate issued by a U.S. bank representing shares of a foreign company, facilitating U.S. investment in non-U.S. entities.
• ADRs trade and settle in U.S. dollars on American exchanges, simplifying transactions for domestic investors.
• They provide foreign companies with access to the U.S. capital markets without requiring a direct listing on a U.S. exchange.
• There are different types of ADR programs (Level 1, Level 2, Level 3, Unsponsored), each with varying listing and Securities and Exchange Commission (SEC) reporting requirements.
• ADRs allow U.S. investors to gain exposure to foreign companies and potentially diversify their investment portfolios.

Formula and Calculation

An American Depositary Receipt does not have a "formula" in the traditional sense of a financial calculation. Instead, its value is directly tied to the price of the underlying security in its home market and the prevailing foreign exchange rate.

The relationship between the ADR price and the foreign share price is determined by a pre-set ratio. This ratio dictates how many underlying foreign shares one ADR represents. For example, one ADR might represent one foreign share, or it could represent a fraction of a share, or even multiple shares. This ratio is often "adjusted" by the depositary bank to ensure the ADR's price is more appealing to U.S. investors, making it trade within a typical U.S. share price range.

F¹¹or example, if a foreign company's shares trade at a very high price in its home currency, the depositary bank might issue ADRs where one ADR represents a fraction of one foreign share to make the ADR price lower and more accessible to a wider range of U.S. investors. Conversely, if a foreign share is very low-priced, one ADR might represent multiple foreign shares.

The approximate price of an ADR can be thought of as:

Where:

• Foreign Share Price: The current trading price of the company's shares in its home market.
• ADR Ratio: The number of foreign shares represented by one ADR.
• Exchange Rate: The rate at which the foreign currency converts to U.S. dollars.

This "adjustment" of the ratio is a key feature that allows ADRs to be priced comparably to other U.S. stocks, regardless of the foreign share's nominal value.

Interpreting the American Depositary Receipt

Interpreting an American Depositary Receipt primarily involves understanding its relationship to the underlying foreign stock. An ADR allows an investor to own a piece of a non-U.S. company, with all the associated benefits and risks, without the complexities of directly purchasing shares on a foreign exchange.

When evaluating an American Depositary Receipt, investors should consider not only the financial health and prospects of the foreign company, often assessed through its financial statements, but also the economic and political conditions of the company's home country. The performance of an ADR will largely mirror the performance of the foreign company's shares in its home market, adjusted for the ADR ratio and any fluctuations in foreign exchange rates. Moreover, the liquidity of an ADR, or how easily it can be bought and sold, is an important factor. Actively traded ADRs tend to have higher liquidity, making them more attractive to investors.

Hypothetical Example

Imagine a hypothetical Japanese technology company, "Tech Innovations Japan" (TIJ), whose shares trade on the Tokyo Stock Exchange for ¥10,000 per share. A U.S. depositary bank decides to create an American Depositary Receipt program for TIJ.

To make the ADR price more accessible to U.S. investors, the bank establishes an ADR ratio where 1 ADR represents 0.10 of a TIJ share. Let's assume the current exchange rate is ¥150 to $1.

1. Value of 0.10 TIJ shares in Yen: 0.10 shares * ¥10,000/share = ¥1,000
2. Convert to U.S. Dollars: ¥1,000 / ¥150 per dollar = $6.67

So, one ADR for Tech Innovations Japan would trade at approximately $6.67 on a U.S. stock exchange. If a U.S. investor wanted to buy the equivalent of one full TIJ share, they would need to purchase 10 ADRs (since each ADR represents 0.10 of a share). This "adjustment" in the ratio makes the ADR price more aligned with typical U.S. stock prices, making it easier for investors using a domestic brokerage account to invest in TIJ.

Practical Applications

American Depositary Receipts are widely used for several practical applications in global finance and investment:

• Facilitating Cross-Border Investment: ADRs enable U.S. investors to gain exposure to foreign companies without needing to open international brokerage accounts or deal with foreign currencies and settlement systems. This accessibility broadens investment horizons and supports portfolio diversification.
• Accessing U.S. Capital Markets: For non-U.S. companies, ADRs provide a vital pathway to raise capital from U.S. institutional investors and retail investors, increasing their market capitalization and global visibility. This is ¹⁰particularly true for Level 3 ADR programs, which allow foreign companies to issue new shares to raise capital in the U.S..
• Si⁹mplified Corporate Actions: ADRs simplify the process of receiving dividends and exercising voting rights for foreign shares, as the depositary bank handles the currency conversion and administrative tasks. This red⁸uces the administrative burden on individual investors.
• Regulatory Framework: The Securities and Exchange Commission (SEC) regulates ADRs, requiring different levels of disclosure depending on the type of ADR program. For instance, Level 2 and Level 3 ADRs necessitate more comprehensive financial reporting by the foreign company, offering greater transparency to U.S. investors. The SEC ⁷provides investor bulletins to explain these instruments and their associated regulations.

Limi⁶tations and Criticisms

Despite their advantages, American Depositary Receipts come with certain limitations and criticisms:

• Disclosure Differences: While sponsored ADRs typically require foreign companies to file reports with the SEC, the level of disclosure may still differ from that required of U.S. domestic companies. Investors might find that the financial statements are not as extensive or comparable to U.S. Generally Accepted Accounting Principles (GAAP) standards, particularly for Level 1 ADRs traded on the Over-the-Counter Market.
• Cu⁵rrency Risk: Although ADRs trade in U.S. dollars, investors are still exposed to foreign exchange risk. Fluctuations in the exchange rate between the U.S. dollar and the foreign company's home currency can impact the value of the ADR, even if the underlying share price remains stable in its local currency.
• Liquidity Concerns: Some ADRs, especially those for smaller foreign companies or unsponsored programs, may have lower trading volumes and thus less liquidity compared to actively traded domestic stocks. This can make it challenging to buy or sell large blocks of ADRs without significantly impacting the price.
• Fees: Depositary banks charge various fees associated with ADRs, including fees for issuing and canceling ADRs, passing through dividends, and foreign currency exchange. These fees can erode investor returns, and it is important for investors to understand them by reviewing the ADR's registration statement.

Amer⁴ican Depositary Receipt vs. Global Depositary Receipt

While both American Depositary Receipts (ADRs) and Global Depositary Receipts (GDRs) are negotiable certificates that facilitate investment in foreign companies, their primary distinction lies in their target markets and listing venues.

An American Depositary Receipt (ADR) is specifically designed for the U.S. market. It is issued by a U.S. depositary bank and typically trades on U.S. stock exchanges (like the NYSE or NASDAQ) or the Over-the-Counter Market. ADRs are denominated in U.S. dollars and primarily cater to U.S. investors, simplifying their access to foreign equities.

A Global Depositary Receipt (GDR), on the other hand, is a broader instrument. It is issued by an international depositary bank and can be traded on multiple stock exchanges around the world, including London, Luxembourg, or other European markets, as well as sometimes in the U.S. GDRs are often denominated in U.S. dollars or euros and are designed to attract a wider global investor base, not just those in the United States. Therefore, while all ADRs are a type of depositary receipt, GDRs offer a more expansive reach for companies seeking capital from diverse international markets.

FAQs

What are the different types of American Depositary Receipts?

There are generally three "levels" of sponsored American Depositary Receipts and also unsponsored ADRs. Level 1 ADRs have minimal SEC reporting requirements and trade on the Over-the-Counter Market. Level 2 ADRs can be listed on a U.S. stock exchange but cannot be used to raise capital directly. Level 3 ADRs have the most stringent SEC reporting requirements and allow foreign companies to raise new capital by offering shares in the U.S. Unsponsored ADRs are created by depositary banks without the direct involvement or cooperation of the foreign company.

Can³ I receive dividends from an ADR?

Yes, investors who own American Depositary Receipts typically receive dividends from the underlying foreign company. The depositary bank collects the dividends in the foreign currency, converts them into U.S. dollars, and then distributes them to the ADR holders. This process simplifies dividend collection for U.S. investors, as they do not need to deal with foreign exchange conversions themselves.

Are² ADRs risky?

Like any investment, American Depositary Receipts carry risks. These include the inherent risks of investing in equities, such as market volatility and company-specific risks. Additionally, ADRs expose investors to specific international risks, such as currency fluctuations, political instability in the foreign company's home country, and differences in regulatory and accounting standards. It is important for investors to conduct thorough research on the foreign company and its operating environment before investing in an ADR.

Do I pay foreign taxes on ADR dividends?

Depending on the country where the foreign company is based, dividends paid on American Depositary Receipts may be subject to foreign withholding taxes. However, many countries have tax treaties with the U.S. that can reduce or eliminate these foreign taxes. In some cases, U.S. investors may be able to claim a foreign tax credit on their U.S. tax return for any foreign taxes paid. Investors should consult a tax advisor regarding their specific situation and review the ADR's registration statement for details on applicable fees and taxes.

How do I buy American Depositary Receipts?

American Depositary Receipts can be bought and sold through a standard U.S. brokerage account, similar to how one would trade shares of a domestic company. They are listed on major U.S. stock exchanges or traded over-the-counter. Investors can place buy or sell orders with their broker, who then executes the trade in the U.S. market. The process is designed to be as seamless as trading domestic U.S. stocks.¹