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Advanced depository receipt

What Is American Depositary Receipt (ADR)?

An American Depositary Receipt (ADR) is a negotiable certificate issued by a U.S. depositary bank that represents shares of a non-U.S. company. These certificates trade on U.S. stock markets and are denominated in U.S. dollars, making it easier for American investors to own shares in foreign companies without directly trading on foreign exchanges. ADRs fall under the broader category of international investing, providing a mechanism for cross-border diversification. The shares underlying an ADR are held by the U.S. depositary bank, or its custodian, in the foreign company's home country.

History and Origin

The concept of depositary receipts emerged to overcome the complexities U.S. investors faced when trying to buy shares in foreign companies, including differing trading practices, settlement procedures, and currency conversions. JPMorgan's predecessor, Guaranty Trust Company, pioneered the American Depositary Receipt in 1927.25,24 The first ADR was created for Selfridges Provincial Stores Limited, a British retailer, and was listed on the New York Curb Exchange, the precursor to the American Stock Exchange.23,22 This innovation significantly simplified international equity investments for U.S. investors, providing a more accessible pathway to global capital markets.

Key Takeaways

  • ADRs are certificates issued by U.S. banks representing shares of non-U.S. companies.
  • They trade on U.S. exchanges, facilitating international investing for American investors.
  • ADRs are denominated in U.S. dollars, simplifying pricing and dividend payments.
  • They provide a liquid way for U.S. investors to gain exposure to foreign stocks.
  • Different levels of ADR programs exist, with varying regulatory requirements and access to U.S. markets.

Formula and Calculation

An American Depositary Receipt (ADR) does not have a "formula" in the traditional sense of a mathematical equation to determine its value. Instead, its price is directly linked to the value of its underlying shares in the foreign company's home market, adjusted by a predetermined ratio.

The relationship between an ADR's price and its underlying foreign share can be expressed as:

ADR Price=Foreign Share Price×ADR RatioForeign Currency Exchange Rate to USD\text{ADR Price} = \frac{\text{Foreign Share Price} \times \text{ADR Ratio}}{\text{Foreign Currency Exchange Rate to USD}}

Where:

  • ADR Price: The trading price of one American Depositary Receipt in U.S. dollars.
  • Foreign Share Price: The trading price of one ordinary share of the foreign company in its home currency.
  • ADR Ratio: The number of foreign ordinary shares represented by one ADR. This ratio is set by the depositary bank and can be one-for-one, a fraction, or multiple shares.21,
  • Foreign Currency Exchange Rate to USD: The current exchange rate converting the foreign currency to U.S. dollars.

This relationship ensures that an ADR's price closely tracks that of the company's stock on its home exchange, a phenomenon largely maintained by arbitrage opportunities.

Interpreting the ADR

Interpreting an American Depositary Receipt involves understanding its equivalence to the underlying foreign shares and the implications for a U.S. investor. An ADR's ratio, set by the depositary bank, dictates how many foreign ordinary shares one ADR represents. For example, if an ADR has a 1:5 ratio, one ADR is equivalent to five shares of the foreign company's stock in its home market. This ratio allows ADRs to be priced at an amount typical of U.S. share prices, preventing them from appearing either too expensive or too similar to lower-priced "penny stocks."20,

When evaluating an ADR, investors should consider the financial health of the foreign companies themselves, as the ADR's performance is directly tied to the underlying stock. It's also important to understand the specific level of the ADR program (Level I, II, or III), as this determines the amount of regulatory disclosure and the trading venue. More advanced ADR levels typically imply greater transparency and broader market access.

Hypothetical Example

Consider "GloboCorp," a fictional company based in Germany, whose shares trade on the Frankfurt Stock Exchange at €50 per share. A U.S. depositary bank decides to issue American Depositary Receipts for GloboCorp.

  1. Setting the Ratio: The bank determines that a 1:2 ADR ratio would be appropriate, meaning one ADR will represent two ordinary shares of GloboCorp. This aims to give the ADR a reasonable price point in U.S. dollars.
  2. Currency Conversion: Assume the current exchange rate is €1 = $1.10.
  3. ADR Creation: A U.S. investor wants to buy GloboCorp shares through an ADR. The depositary bank purchases two GloboCorp shares (totaling €100) on the Frankfurt exchange and holds them in custody.
  4. ADR Issuance: The bank then issues one ADR to the U.S. investor.
  5. ADR Price Calculation: The value of the two underlying shares in U.S. dollars is €100 * $1.10/€ = $110. Therefore, the ADR would initially be priced around $110, excluding any fees or market premiums/discounts.
  6. Trading: The investor can now buy and sell this GloboCorp ADR on a U.S. exchange, such as the New York Stock Exchange, just like any domestic stock. If GloboCorp declares a dividend of €1 per share, the ADR holder would receive $2.20 (2 shares * €1/share * $1.10/€), minus any applicable fees or foreign taxes.

This example illustrates how the ADR structure facilitates U.S. investor access to foreign equities, simplifies transactions in U.S. dollars, and allows for easier calculation of dividends.

Practical Applications

American Depositary Receipts serve several key purposes in global financial markets and international investing. For U.S. investors, ADRs provide simplified access to foreign companies that may not be directly listed on U.S. stock markets. This accessibility includes trading, settlement, and dividend payments all in U.S. dollars, avoiding the complexities of foreign currency exchange and international brokerage accounts., ADRs also allow19 for greater portfolio diversification by enabling exposure to international economies and industries.

For foreign companies, issuing ADRs is a strategic move to tap into the vast U.S. capital markets and raise capital without undergoing the full, often more burdensome, process of a direct listing on a U.S. exchange. By listing ADRs, foreign firms can gain greater visibility among American investors and financial analysts, potentially leading to increased liquidity for their shares. Market participants generally categorize ADRs into three "levels," depending on the extent to which the foreign company has accessed the U.S. markets and their corresponding regulatory requirements by the U.S. Securities and Exchange Commission (SEC). Level 1 program18s establish a trading presence, typically on the over-the-counter market, but cannot be used to raise capital. Level 2 program17s allow exchange listing but also not for raising capital., Level 3 progra16m15s, which are the most stringent, permit both exchange listing and public offerings to raise capital.,

Limitation14s13 and Criticisms

While American Depositary Receipts offer numerous advantages, investors should also be aware of their limitations and potential risks. One significant concern is exchange rate risk. Although ADRs trade in U.S. dollars, their value is still influenced by the fluctuation of the foreign company's home currency against the U.S. dollar., A weakening of 12the foreign currency can negatively impact the ADR's value, even if the underlying company's performance remains strong in its local currency.

Another limitation relates to the disclosure requirements for foreign companies. While Level 2 and Level 3 ADRs require foreign companies to meet reporting standards similar to those for U.S. companies (such as filing annual reports on Form 20-F with the SEC), Level 1 ADRs have minimal reporting requirements, which can limit the financial information available to investors.,, This reduced 11t10r9ansparency can make it harder for investors to conduct thorough due diligence compared to U.S.-listed stocks.

Furthermore, investing in ADRs carries political risk. Changes in the political or economic conditions of the issuing company's home country can significantly impact the company's financial results and, consequently, the ADR's price., Investors may 8a7lso incur additional fees, such as custody fees charged by the depositary bank for holding the underlying shares, or currency conversion fees deducted from dividends., These charges c6an reduce overall returns. The U.S. Securities and Exchange Commission provides detailed investor bulletins to educate the public on the various considerations and risks associated with ADRs.

American De5positary Receipt (ADR) vs. Global Depository Receipt (GDR)

American Depositary Receipts (ADRs) and Global Depository Receipts (GDRs) are both types of equity derivative instruments that allow investors to own shares in foreign companies without directly purchasing them on foreign exchanges. The 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 trades on U.S. exchanges like the NYSE, Nasdaq, or on the over-the-counter market. ADRs are denominated in U.S. dollars and are subject to regulation by the U.S. Securities and Exchange Commission (SEC). Their purpose is to facilitate U.S. investor access to foreign equities.

In contrast, a Global Depository Receipt (GDR) is issued by an international depositary bank and can be traded on multiple international exchanges outside the company's home market, typically in financial centers like London or Luxembourg. GDRs are often denominated in U.S. dollars or euros and cater to a broader global investor base, not just U.S. investors. While ADRs are a subset of depositary receipts focused on the American market, GDRs offer wider access to global capital markets.

FAQs

What is the main benefit of investing in an American Depositary Receipt (ADR)?

The main benefit of investing in an American Depositary Receipt (ADR) is that it allows U.S. investors to gain exposure to foreign companies without the complexities of direct international stock purchases. ADRs trade in U.S. dollars, settle through U.S. systems, and can be bought and sold through a U.S. brokerage firm.

Are American Depositary Receipts (ADRs) subject to U.S. taxes?

Yes, like other U.S. investments, American Depositary Receipts are generally subject to U.S. income and capital gains taxes. Dividends from ADRs are paid in U.S. dollars, but may be subject to foreign withholding taxes, which can sometimes be offset via tax treaties.,

How is the3 price of an American Depositary Receipt (ADR) determined?

The price of an American Depositary Receipt (ADR) is primarily determined by the price of the underlying shares on the foreign company's home exchange, adjusted for the ADR ratio and the prevailing currency exchange rate risk. Due to arbitrage, the ADR price closely mirrors the price of the foreign stock.

Can all foreign companies issue American Depositary Receipts (ADRs)?

Not all foreign companies issue American Depositary Receipts (ADRs). Issuance depends on whether a U.S. depositary bank establishes a program for the company's shares. For sponsored ADRs, the foreign company actively cooperates with the depositary bank and must meet specific U.S. Securities and Exchange Commission (SEC) reporting requirements, especially for Level 2 and Level 3 programs. Unsponsored ADR2s can exist without the foreign company's direct involvement but have limited trading venues and minimal regulatory oversight.1