What Is American Depositary Receipt (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 non-U.S. company's stock. ADRs allow U.S. investors to invest in foreign companies without having to directly purchase shares on foreign exchanges, thereby facilitating international investing as part of broader portfolio diversification strategies within the global financial markets. These receipts trade in U.S. dollars and clear through U.S. settlement systems, which simplifies transactions for American investors by avoiding foreign currency exchange complexities.35, 36
History and Origin
The concept of the American Depositary Receipt was pioneered in 1927 by Guaranty Trust Company, a predecessor firm to J.P. Morgan.33, 34 The very first ADR was created to allow U.S. investors to purchase shares of the British department store, Selfridges Provincial Stores Limited.31, 32 This innovation addressed the challenges American investors faced in buying shares directly on international exchanges, which was often impractical for the average person. By establishing ADRs, U.S. investors gained easier access to foreign equities, while non-U.S. companies found a simpler pathway to access the U.S. capital markets.30
Key Takeaways
- ADRs are U.S. dollar-denominated certificates representing shares of foreign companies, enabling American investors to invest internationally.29
- They are issued by U.S. depositary banks and trade on U.S. exchanges or over-the-counter markets.27, 28
- Each ADR may represent one or more underlying foreign shares, or even a fraction of a share, allowing for more familiar pricing in the U.S. market.26
- ADRs simplify cross-border investing by handling currency conversions and settlement processes.24, 25
Formula and Calculation
While there isn't a specific "formula" for the American Depositary Receipt itself, its value is directly tied to the underlying foreign shares it represents. The price of an ADR corresponds to the price of the foreign stock in its home market, adjusted by the ratio of ADRs to foreign company shares.23 This ratio is crucial in determining the equivalent U.S. dollar value of the foreign stock.
For example, if an ADR represents 5 shares of a foreign company, and the foreign share trades at €10, then the ADR's theoretical value would be 5 times the €10 equivalent in U.S. dollars, factoring in the prevailing exchange rate.
The calculation of an ADR's price can be expressed as:
Where:
Foreign Share Priceis the price of one share of the foreign company in its local currency.ADR Ratiois the number of foreign shares represented by one ADR.Exchange Rateis the conversion rate from the foreign currency to the U.S. dollar.
This relationship ensures that the ADR's price closely tracks the performance of its underlying foreign securities.
Interpreting the American Depositary Receipt
Interpreting an American Depositary Receipt involves understanding its relationship to the underlying foreign stock and the implications for U.S. investors. An ADR's price will move in tandem with the foreign company's shares in its home market, adjusted for the ADR ratio and the currency exchange rate. Investors often use ADRs to gain exposure to international markets and companies that may not be directly listed on U.S. exchanges.
The ratio of ADRs to foreign shares is set by the depositary bank to make the ADR's price more appealing to U.S. investors, often aligning it with typical U.S. stock prices. For22 example, a high-priced foreign stock might have an ADR ratio where one ADR represents multiple foreign shares, making the ADR cheaper and more liquid for U.S. investors. Conversely, a low-priced foreign stock might have an ADR representing a fraction of a share. Understanding this ratio is vital for comparing the ADR's performance to the actual foreign stock.
Furthermore, investors should consider the type of ADR, as it indicates the level of SEC registration and regulatory oversight. Different types of ADRs, such as sponsored and unsponsored, offer varying degrees of reporting and investor protection. Regulatory filings provide insight into the company's financial health and operations.
Hypothetical Example
Imagine an American investor, Sarah, wants to invest in "GlobalTech," a fast-growing technology company based in Japan. GlobalTech's shares trade on the Tokyo Stock Exchange for ¥5,000 per share. Directly buying shares on the Tokyo exchange would involve opening a foreign brokerage account, dealing with yen, and navigating Japanese market regulations.
Instead, GlobalTech has an American Depositary Receipt program in the U.S., with each ADR representing 2 GlobalTech shares. The current exchange rate is ¥110 to $1 USD.
-
Calculate the value of the underlying shares per ADR:
2 shares * ¥5,000/share = ¥10,000 -
Convert the yen value to U.S. dollars:
¥10,000 / ¥110 per $1 USD = $90.91
So, the theoretical price of one GlobalTech ADR would be approximately $90.91.
Sarah can now buy GlobalTech ADRs through her regular U.S. brokerage account, just like any other U.S. stock. If GlobalTech's share price in Japan goes up or down, or if the currency exchange rate changes, the price of the ADR will reflect these movements. This allows Sarah to invest in a Japanese company using U.S. dollars, simplifying her international investment.
Practical Applications
American Depositary Receipts serve several practical purposes for investors and foreign companies in the realm of global finance. For U.S. investors, ADRs provide a convenient and efficient way to gain exposure to foreign companies and diversify their portfolios geographically. Instead o21f dealing with foreign stock exchanges, currency conversions, and different settlement procedures, investors can buy and sell ADRs through their domestic brokerage accounts, much like they would U.S. common stocks. This ease of access can broaden investment opportunities beyond domestic borders, enabling participation in the growth of various international economies.
For non-20U.S. companies, ADRs offer a mechanism to tap into the vast U.S. capital markets. By issuing ADRs, foreign companies can raise capital from American investors and enhance their visibility among a broader base of shareholders. This acce19ss to U.S. equity markets can be crucial for funding expansion, mergers, and acquisitions.
ADRs are classified into different "levels," which indicate the degree of regulatory oversight and the listing venue. Level I ADRs are the easiest to establish and trade on the over-the-counter (OTC) market, offering limited financial reporting. Level II 18and Level III ADRs are listed on major U.S. stock exchanges like the New York Stock Exchange (NYSE) or NASDAQ, requiring more stringent U.S. Securities and Exchange Commission (SEC) registration and reporting compliance, making them suitable for institutional investors and retail investors alike.
For inst16, 17ance, the Chinese ride-hailing company Didi Global initially pursued an initial public offering (IPO) in the U.S. through an ADR listing on the NYSE in 2021. However, due to regulatory pressures from Chinese authorities regarding data security, Didi announced its intention to delist its ADRs from the NYSE and explore a listing in Hong Kong. This even12, 13, 14, 15t highlighted the potential for geopolitical and regulatory risks to impact ADR programs and the importance of understanding the regulatory environment of both the issuing country and the U.S.
Limit11ations and Criticisms
Despite their advantages, American Depositary Receipts come with certain limitations and criticisms. One significant concern is the potential for "pre-released" ADRs, where a depositary bank issues ADRs without the corresponding foreign shares being held in custody. This practice can lead to an oversupply of ADRs relative to the actual underlying shares, potentially impacting market integrity and price discovery. In 2018, BNY Mellon paid over $54 million to settle charges by the SEC related to improper handling of such pre-released ADRs. This inci10dent underscores the importance of regulatory oversight in the ADR market and the risks associated with non-compliance.
Another limitation can arise from liquidity, particularly for unsponsored ADRs or those from smaller, less-known foreign companies. While major ADRs listed on prominent exchanges often have robust liquidity, some ADRs traded over-the-counter may have lower trading volumes, making it more challenging for investors to buy or sell significant quantities without impacting the price. This can increase transaction costs and reduce investment flexibility.
Furthermore, investors in ADRs are still exposed to currency risk. Although ADRs trade in U.S. dollars, the value of the underlying foreign shares is denominated in a foreign currency. Fluctuations in exchange rates between the U.S. dollar and the foreign currency can impact the dollar-denominated value of the ADR, even if the foreign company's stock price remains stable in its local currency. This means that an appreciation of the U.S. dollar against the foreign currency would decrease the value of the ADR, and vice-versa.
Investors may also face complexities related to foreign taxation on dividends and capital gains, as well as potential delays in receiving corporate communications or exercising voting rights compared to direct shareholders. While ADRs aim to simplify international investing, understanding these nuances is crucial for managing investment risk.
American Depositary Receipt (ADR) vs. Global Depositary Receipt (GDR)
While both American Depositary Receipts (ADRs) and Global Depositary Receipts (GDRs) are types of depositary receipts that facilitate investment in foreign companies, they differ primarily in their target markets and listing venues.
An American Depositary Receipt (ADR) is specifically designed for the U.S. market, issued by a U.S. depositary bank, and trades on U.S. exchanges (NYSE, NASDAQ) or the over-the-counter (OTC) market. This stru8, 9cture makes it easy for American investors to buy shares of non-U.S. companies using U.S. dollars and through U.S. settlement systems.
In contrast, a Global Depositary Receipt (GDR) is a more globally oriented instrument. GDRs are typically issued by an international depositary bank and are designed to be traded on multiple international exchanges, such as the London Stock Exchange (LSE) or the Luxembourg Stock Exchange. While ADR7s specifically target U.S. investors, GDRs aim to attract a broader base of investors from various countries, providing foreign companies with access to a wider pool of global capital. An investor might hold a global depositary receipt for a company listed in Europe, for example, rather than an ADR.
FAQs
How does an ADR relate to the actual foreign shares?
An American Depositary Receipt represents a specific number of shares of a foreign company's stock that are held in custody by a U.S. depositary bank or its overseas custodian. Each ADR 6certificate details the ratio of ADRs to the underlying foreign shares, which can be one-for-one, multiple shares, or a fraction of a share.
What5 are the benefits of investing in ADRs for U.S. investors?
ADRs offer U.S. investors a simplified way to invest in foreign companies without navigating foreign stock exchanges, different currencies, or international settlement procedures. They trade in U.S. dollars and settle through U.S. systems, making them as convenient as investing in domestic stocks. This allo3, 4ws for greater geographic diversification within a portfolio.
Are all ADRs the same?
No, ADRs are categorized into different "levels" based on their issuer's involvement and the extent of their regulatory compliance in the U.S. Level I ADRs are the least regulated and trade over-the-counter. Level II and Level III ADRs are more rigorously regulated by the SEC and are listed on major U.S. stock exchanges, offering greater transparency and liquidity.
How 1, 2do I receive dividends from an ADR?
If the underlying foreign company pays dividends, the U.S. depositary bank converts these dividends from the foreign currency into U.S. dollars and then distributes them to the ADR holders. This process typically incurs certain fees for currency conversion and administration. This is a key aspect of passive income generation for ADR investors.
What risks are associated with ADRs?
Key risks include currency risk, as fluctuations in exchange rates can impact the ADR's value. There's also geopolitical risk, as events in the foreign company's home country can affect its stock performance. Additionally, some ADRs, particularly unsponsored ones, may have less stringent reporting requirements compared to U.S.-listed stocks. Understanding these risks is part of a broader risk management strategy.