Adr

What Is an ADR?

An American Depositary Receipt (ADR) is a negotiable certificate issued by a U.S. depositary bank that represents a specified number of shares of a foreign company's stock. These certificates allow U.S. investors to buy shares in non-U.S. companies on U.S. stock market exchanges, simplifying the process of international investing. ADRs are denominated in U.S. dollars and are priced and traded in dollars, clearing through U.S. settlement systems. This structure helps bridge the gap between foreign companies seeking to access U.S. capital markets and American investors looking for portfolio diversification by investing in global equities. An ADR is essentially a convenient wrapper around foreign shares, making them accessible to a wider investor base in the United States.

History and Origin

The concept of American Depositary Receipts was pioneered by J.P. Morgan's predecessor firm, Guaranty Trust Company, in 1927. The first ADR was created for Selfridges Provincial Stores Limited, a British retailer, on April 29, 1927, and was listed on the New York Curb Exchange, the precursor to the American Stock Exchange.¹¹, ¹², ¹³ This innovation enabled American investors to participate in foreign securities directly on U.S. exchanges, addressing the complexities of buying shares in overseas countries and managing different currencies and trading conventions. The development of the ADR facilitated easier cross-border investment and allowed foreign firms to attract capital from the burgeoning U.S. market without the full hassle and expense of a direct listing.

Key Takeaways

• ADRs are U.S. dollar-denominated certificates representing shares of a non-U.S. company.
• They allow U.S. investors to trade foreign stocks on U.S. exchanges.
• ADRs are issued by U.S. depositary banks.
• They simplify international investing by eliminating the need for direct foreign currency transactions.
• ADRs can be sponsored by the foreign company or unsponsored.

Formula and Calculation

An ADR itself does not have a "formula" in the traditional sense of a financial ratio. Instead, its value is directly linked to the price of the underlying security in its home market and the prevailing foreign exchange rate. Each ADR represents a specific number of ordinary shares of the foreign company, known as the "ADR ratio" or "conversion rate."

For example, if one ADR represents five ordinary shares of a company traded on a foreign exchange, the relationship can be expressed as:

This conversion rate establishes the link between the ADR and the locally traded security. Movements in the exchange rate of the home country's currency versus the U.S. dollar are reflected in the price of the U.S.-traded ADR.¹⁰

Interpreting the ADR

Interpreting the ADR involves understanding its value in relation to the foreign company's local shares and the broader global market. An ADR's price on a U.S. exchange will generally track the price of the underlying security in its home market, adjusted for the ADR ratio and the foreign exchange rate. Investors considering an ADR should examine the financial health of the foreign company, its industry, and the economic conditions of its home country. While ADRs are traded in U.S. dollars, their value is still exposed to fluctuations in the foreign currency. Furthermore, the type of ADR program (sponsored vs. unsponsored) can influence the availability of financial information and the level of the foreign company's involvement.

Hypothetical Example

Imagine an investor in the United States wants to purchase shares of "GlobalTech Inc.," a fictional technology company based in Japan. GlobalTech Inc. shares trade on the Tokyo Stock Exchange at ¥1,000 per share. A U.S. depositary bank has established an ADR program for GlobalTech, with an ADR ratio of 1:10 (meaning one ADR represents 10 GlobalTech ordinary shares).

If the exchange rate is ¥150 to $1, the theoretical price of one GlobalTech ADR would be:

An investor could then purchase the GlobalTech ADRs on a U.S. exchange through their brokerage account for approximately $66.67 per ADR, rather than needing to open an account in Japan and convert currency.

Practical Applications

ADRs are widely used in international equity investing as a bridge to foreign markets. They provide U.S. investors with a simplified way to gain exposure to foreign companies, offering access to growth opportunities and facilitating portfolio diversification. ADRs can be listed on major U.S. stock exchanges like the New York Stock Exchange (NYSE) and Nasdaq, as well as traded on the Over-the-Counter Market. The Securities and Exchange Commission (SEC) regulates ADRs, requiring disclosure of fees and payments between depositary banks and foreign issuers. They ⁹allow foreign companies to tap into the vast U.S. capital markets to raise capital or establish a trading presence without the full complexities of a direct listing. For example, many prominent global companies have ADR programs to facilitate U.S. investor access. The U.S. Securities and Exchange Commission provides an investor bulletin that details how ADRs function and their regulatory oversight.

L⁸imitations and Criticisms

While ADRs offer convenience, they are not without limitations. A primary concern for investors is currency risk. Even though ADRs trade in U.S. dollars, their value is inherently linked to the underlying foreign shares and the exchange rate between the U.S. dollar and the foreign currency. If the foreign currency depreciates against the U.S. dollar, the value of the ADR will likely decline, even if the foreign company's local share price remains stable. This ⁷is a common misconception, as many investors assume that trading in dollars eliminates this exposure.

Anot⁶her limitation can be the limited selection of foreign companies available as ADRs compared to the vast universe of global stocks. Some ADR programs, particularly unsponsored ones, may also offer less transparency regarding the foreign company's financial information, as they do not require the same level of reporting to the Securities and Exchange Commission as sponsored programs. Furth⁵ermore, investors may incur certain fees charged by the depositary bank, such as custody fees or dividend conversion fees, which can impact overall returns. Resea⁴rch by entities like the Federal Reserve Bank of St. Louis also highlights broader risks associated with international investment, such as geopolitical instability, that can indirectly affect ADRs.

A³DR vs. American Depositary Share (ADS)

The terms American Depositary Receipt (ADR) and American Depositary Share (ADS) are often used interchangeably, leading to some confusion. However, there is a technical distinction. An American Depositary Share (ADS) refers to the actual security that represents an ownership interest in the deposited foreign shares. In contrast, an ADR is the physical certificate (or the electronic record) that evidences ownership of one or more ADSs. Think of it this way: the ADS is the unit of ownership, while the ADR is the document or instrument that certifies that ownership. For practical trading purposes, investors typically refer to buying or selling an "ADR," implying they are trading the underlying ADSs. The depositary bank issues ADSs, which are then bundled to form an ADR certificate.

F¹, ²AQs

What are the different types of ADRs?

ADRs are generally categorized into sponsored and unsponsored programs. Sponsored ADRs are established with the direct involvement and permission of the foreign company, which often pays the costs and retains control. These are further categorized into Level I, Level II, and Level III, depending on the degree of SEC compliance and listing requirements. Unsponsored ADRs are set up by a depositary bank without the foreign company's direct participation.

Do ADRs pay dividends?

Yes, many ADRs pay dividends. When the foreign company declares a dividend, the depositary bank receives the dividend in the foreign currency, converts it into U.S. dollars, and then distributes it to ADR holders, typically after deducting any applicable fees or taxes.

What are the risks of investing in ADRs?

Key risks include currency risk, where fluctuations in the exchange rate between the U.S. dollar and the foreign currency can impact returns. Other risks include political and economic instability in the foreign company's home country, liquidity risk if the ADR trades thinly, and potential differences in accounting standards or regulatory oversight compared to U.S. equities.

How does an ADR simplify international investing?

An ADR simplifies international equity investing by allowing U.S. investors to buy and sell foreign company shares through their domestic brokerage accounts, in U.S. dollars. This eliminates the need to open accounts in foreign markets, deal with foreign currency conversions for trades, or navigate unfamiliar foreign settlement systems.